2045
USING A HYBRID SECURITIES TEST TO TACKLE
THE PROBLEM OF PYRAMID FRAUD
Corey Matthews*
This Note examines federal securities law as a tool to deter and regulate
illegal pyramid schemes. Pyramid schemes are among the most prevalent
forms of consumer fraud in the United States and they victimize thousands of
individuals every year. The rise of the internet and social media has made it
even easier for pyramid promoters to target potential recruits, often those
who are already particularly vulnerable to consumer fraud. The federal
securities laws have proven to be robust regulatory tools against pyramid
schemes. However, the test used by federal courts to determine whether a
scheme meets the definition of a security has produced uncertainty and
inconsistency in the law. This Note proposes that when pyramid schemes are
alleged, federal courts should apply a hybrid securities test that incorporates
aspects of risk capital analysis. In so doing, courts will be better equipped
to focus on the economic reality of pyramid schemes and to draw a more
principled line between illegal pyramid fraud and legitimate enterprises.
I
NTRODUCTION ................................................................................ 2046
I. CLASSIFICATION AND REGULATION OF PYRAMID SCHEMES ...... 2049
A. Separating Fraud from Fair Play ................................... 2050
1. Fair Play: Legal MLM Companies and Their
Advantages .............................................................. 2051
2. Fraud: Illegal Pyramid Schemes ............................. 2052
B. Pyramid Fraud and the Harm to Consumers ................. 2055
C. The Landscape of Existing Laws and Regulations ......... 2058
1. The States ................................................................. 2059
2. The FTC ................................................................... 2061
3. The SEC ................................................................... 2063
II. WHEN A PYRAMID IS ALSO A SECURITY: DIFFERENT TESTS
FOR FINDING AN “INVESTMENT CONTRACT” ....................... 2065
* J.D. Candidate, 2021, Fordham University School of Law; B.A., 2016, Cornell University.
I would like to thank Professor Caroline Gentile for her invaluable guidance and insight, the
editors and staff of the Fordham Law Review for their input and diligence, and my family and
friends for their unwavering support and encouragement.
2046 FORDHAM LAW REVIEW [Vol. 88
A. Application of the Howey Test to Pyramid Schemes ...... 2066
1. Liberalization of Howey’s “Efforts of Others”
Prong ....................................................................... 2067
2. Differing Interpretations of Managerial Efforts ....... 2068
B. Risk Capital Analysis and the Hawaii Market Center
Test................................................................................ 2070
1. The Development of Risk Capital Analysis ............. 2071
2. Reception by the Federal Courts .............................. 2073
III. JOINING FORCES: A COMBINED HOWEY–HAWAII MARKET
C
ENTER TEST ........................................................................ 2075
A. Why Securities Protections Should Properly Be
Applied to Pyramid Schemes ........................................ 2076
B. The Relationship Between Investor Effort and Investor
Control .......................................................................... 2077
C. Harmonizing Howey and Hawaii Market Center:
Incorporating Practical and Actual Control ................ 2079
D. Clarity and Consistency: Applying the Combined
Test................................................................................ 2081
CONCLUSION ................................................................................... 2083
INTRODUCTION
In April 1987, the New York Times published an article warning readers
about the rising popularity of illegal “airplane” games cropping up in
communities across the United States.
1
Participants in the game paid an
entrance fee, usually $1500, which entitled them to “passenger” status on the
metaphorical “airplane.”
2
A full airplane typically consisted of a pilot or
captain, two copilots, four flight attendants, and eight passengers.
3
Once the
“airplane” was assembled, the pilot received the $12,000 collected from the
passengers’ entrance fees and rotated out.
4
Subsequently, the two copilots became pilots of their own “airplanes,”
taking half of the passengers with them as flight attendants.
5
The flight
attendants from the original flight became copilots, two on each new flight,
and the game continued.
6
As a player moved up the ranks, he or she was
1. Elizabeth Neuffer, ‘Airplane’: High-Stakes Chain Letter, N.Y. TIMES (Apr. 7, 1987),
https://www.nytimes.com/1987/04/07/nyregion/airplane-high-stakes-chain-letter.html
[https://perma.cc/XTW6-6HG2]; see also Lawrence Kilman, Newest Illegal Pyramid Scheme
Going Up and Up, but Not Away, AP
NEWS (Mar. 23, 1987),
https://apnews.com/7894d03521da555b7ea45e6f78323fbb [https://perma.cc/73PM-4WA2].
2. See, e.g., Sheehan v. Bowden, 572 So. 2d 1211, 1211–12 (Ala. 1990); State v.
DeLuzio, 643 A.2d 535, 536–37 (N.J. 1994) (Ohern, J., dissenting); People v. Riccelli, 540
N.Y.S.2d 74, 74 (App. Div. 1989).
3. See Kilman, supra note 1; Neuffer, supra note 1.
4. Neuffer, supra note 1.
5. Id.
6. Id.
2020] HYBRID SECURITIES AND PYRAMID FRAUD 2047
responsible for recruiting at least one passenger behind them.
7
After several
rounds, a passenger would eventually earn the pilot’s seat—a return of
$12,000 on the $1500 initial payment—often in a matter of days.
8
The only
problem? The game was a classic pyramid scheme: “airplanes” needed a
constant influx of new passengers in order to generate returns.
9
This demand
became harder to fill as ever-increasing “airplanes” branched off to form new
ones.
10
To illustrate: for one pilot to receive a return on his investment,
participants needed to recruit eight passengers.
11
For those eight passengers
to earn pilot status and receive a return, the crew would need sixty-four new
passengers.
12
For those sixty-four passengers to generate a profit, they
collectively needed to bring in 512 additional players.
13
Despite these odds,
for many people, the “airplane” game represented quick and easy money; a
victimless crime so long as recruitment was sustained.
14
Such “get rich quick” schemes have a seductive allure: small investments,
modest effort, and astronomical rates of return.
15
But while many get rich
quick models are easily detected and quickly fade from popularity, others
have proved enduring and obstinate. Illegal pyramid schemes are one such
fraud.
16
An illegal pyramid scheme rewards participants primarily for
recruiting new individuals to join.
17
However, unlike the “airplane” game,
most schemes incorporate the sale of a sham product to disguise the true
nature of the fraud.
18
Despite widespread public awareness and concerted
governmental efforts, illegal pyramid schemes continue to regularly enter the
marketplace.
19
Pyramids have proliferated in the digital age, thanks in great part to the
internet and the ubiquity of social networking.
20
It is easier now, more than
7. Id.
8. See Kilman, supra note 1; Neuffer, supra note 1.
9. See David Enscoe, Pyramid Scheme Takes Off, Thousands Invest in “Plane Game,”
S
UN SENTINEL (Mar. 26, 1987), https://www.sun-sentinel.com/news/fl-xpm-1987-03-26-
8701190859-story.html [https://perma.cc/N4V4-RYH9].
10. See id.
11. Id.
12. Id.
13. Id.
14. See id.; Neuffer, supra note 1.
15. See infra Part I.B.
16. See Andrew Ceresney, Dir., Div. of Enf’t, Sec. & Exch. Comm’n, Address at UIC-
SEC Joint Symposium to Raise Public Awareness: Combating Pyramid Schemes and Affinity
Frauds Opening Remarks (Mar. 2, 2016), https://www.sec.gov/news/speech/ceresney-
remarks-joint-symposium-raise-public-awareness-03022016.html [https://perma.cc/VU6Q-
3H6Y].
17. See United States v. Gold Unlimited, Inc., 177 F.3d 472, 475 (6th Cir. 1999).
18. See Jeffrey A. Babener, Network Marketing and the Law, O
R. ST. B. BULL., May 1997,
at 23, 24.
19. See Ceresney, supra note 16.
20. See James Walsh, Note, “Tis the Time’s Plague When Madmen Lead the Blind”: How
the IRS Can Prevent Pyramid-Scheme Formation (and Why It Should), 67 C
ASE W. RES. L.
REV. 577, 585 (2016); Debra A. Valentine, Former Gen. Counsel, Fed. Trade Comm’n,
Address at the International Monetary Funds Seminar on Current Legal Issues Affecting
Central Banks (May 13, 1998), https://www.ftc.gov/public-statements/1998/05/pyramid-
schemes [https://perma.cc/53DK-34VQ]) (opining that the growth of internet marketing has
2048 FORDHAM LAW REVIEW [Vol. 88
ever, for companies to enlist distributors to sell products like vitamins, beauty
supplies, and home goods through their personal networks.
21
Unfortunately, all illegal pyramids are structurally doomed to fail.
22
Pyramid schemes fundamentally rely upon the continuous recruitment of
new distributors.
23
The enterprises generate revenue not from the sale of
goods to end users but from new distributors’ entrance fees and inventory
purchases.
24
Those distributors are then rewarded with either a bonus or
commission on the purchases made by those they have recruited.
25
All such
schemes, however, inevitably collapse once a given market for new
distributors becomes saturated.
26
Two federal agencies shoulder the main responsibility for regulation and
enforcement in this area: the Federal Trade Commission (FTC) and the
Securities and Exchange Commission (SEC).
27
The FTC typically brings
complaints against pyramids for engaging in unfair and deceptive practices,
28
a violation of section 5 of the Federal Trade Commission Act (FTCA).
29
The
FTC has had some success in shutting down illegal pyramids with this
approach.
30
Under the SEC’s ambit, when courts find that pyramid schemes constitute
securities offerings, various other tools are available to federal regulators and
private litigants.
31
The SEC may pursue pyramids for offering unregistered
been the most significant contributor to pyramid scheme growth in the United States because
electronic commerce allows fraudsters to target victims quickly and cost-effectively).
21. See Walsh, supra
note 20, at 585.
22. See Webster v. Omnitrition Int’l, Inc., 79 F.3d 776, 781 (9th Cir. 1996); Ziven Scott
Birdwell, The Key Elements for Developing a Securities Market to Drive Economic Growth:
A Roadmap for Emerging Markets, 39 G
A. J. INT’L & COMP. L. 535, 561 (2011); Adam
Epstein, Multi-level Marketing and Its Brethren: The Legal and Regulatory Environment in
the Down Economy, 12 A
TLANTIC L.J. 91, 104 (2010); Investor Protection Guide: Pyramid
Scheme, LEGAL INFO. INST.,
https://www.law.cornell.edu/wex/investor_protection_guide_pyramid_scheme
[https://perma.cc/A4DX-7EXU] (last visited Mar. 17, 2020).
23. Clinton D. Howie, Is It a Pyramid Scheme?: Multilevel Marketing and Louisiana’s
“New” Anti-pyramid Statute, 49 L
A. B.J. 288, 289 (2002); see also Rhonda Bundy, Note,
Federal Securities Regulations: Do They Adequately Serve Their Prescribed Purpose of
Protecting Investors from Pyramid Schemes?, 21 M
EM. ST. U. L. REV. 123, 125 (1990).
24. Howie, supra note 23, at 289.
25. Id.; Bundy, supra note 23, at 127.
26. See SEC v. Int’l Loan Network, Inc. (Loan Network II), 968 F.2d 1304, 1308–09 (D.C.
Cir. 1992); Sergio Pareja, Sales Gone Wild: Will the FTC’s Business Opportunity Rule Put
an End to Pyramid Marketing Schemes?, 39 M
CGEORGE L. REV. 83, 85–87 (2008); see also
Bundy, supra note 23, at 128 (noting that market saturation frustrates the ability of late-
entering participants to recoup investments).
27. See Note, Pyramid Schemes: Dare to Be Regulated, 61 G
EO. L.J. 1257, 1257 (1973).
28. See Heidi Liu, The Behavioral Economics of Multilevel Marketing, 14 HASTINGS BUS.
L.J. 109, 117–18 (2018); see also Epstein, supra note 22, at 101–02.
29. 15 U.S.C. § 45 (2018).
30. Walsh, supra note 20, at 587–88.
31. See, e.g., Birdwell, supra note 22, at 562–63 (discussing the SEC’s role in shutting
down pyramid schemes); Bundy, supra note 23, at 124 (noting that of the available avenues
of redress for victims of pyramid fraud, securities law seems to be the most viable solution for
curtailing the problem of high-pressure, fraudulent investment schemes).
2020] HYBRID SECURITIES AND PYRAMID FRAUD 2049
securities, a violation of the Securities Act of 1933,
32
or for violating section
10(b)
33
of the Securities Exchange Act of 1934 and Rule 10b-5
34
, which
prohibit individuals from making materially false or misleading statements
in connection with the sale or purchase of a security.
35
Further, violators who
run afoul of the federal securities laws can also face criminal liability under
federal mail and wire fraud statutes.
36
Additionally, private litigants may
bring suit under the Private Securities Litigation Reform Act of 1995
(PSLRA).
37
Moreover, state-specific securities laws may apply to illegal
pyramids.
38
Both SEC and state security enforcement, however, are
necessarily contingent upon the classification of a pyramid scheme as a
security.
39
Finally, state antipyramid or chain distribution statutes may
prevent and prohibit pyramid schemes.
40
In Part I, this Note explores the various federal and state regulatory and
enforcement regimes targeting pyramid schemes. This Part also considers
the benefits and obstacles of those regulatory approaches. In Part II, this
Note suggests that the federal securities law are viable and useful tools for
shutting down and deterring formation of pyramids schemes. Part II
thereafter analyzes two different tests used to determine whether an illegal
pyramid scheme involves the sale of a security. In Part III, this Note argues
that the final prong of the risk capital test used by some state courts more
accurately captures the economic realities of a pyramid scheme. Further, Part
III argues that in the context of pyramid schemes, incorporating this last
prong of the risk capital test into the current federal test for investment
contracts will better serve the purposes of the federal securities law and
provide stronger tools to protect against pyramid-based fraud.
I.
CLASSIFICATION AND REGULATION OF PYRAMID SCHEMES
Part I explains what a pyramid scheme is and how various governmental
actors approach regulation, enforcement, and prevention of illegal pyramid
fraud. Part I.A provides an overview of the broad distribution model known
as multilevel marketing (MLM) and distinguishes between legitimate MLM
programs and illegal pyramids. Part I.A further explores why illegal
pyramids are doomed to fail, and Part I.B gives an overview of the harmful
effects of pyramid fraud in the United States. Part I.C describes federal- and
state-level governmental regulation of pyramid schemes, while analyzing the
costs and benefits of the various regulatory approaches.
32. See generally 15 U.S.C. § 77e.
33. Id. § 78j.
34. 17 C.F.R. § 240.10b-5 (2019).
35. 15 U.S.C. §§ 78a–78b.
36. See generally id. §§ 77a–77aa.
37. See id. § 78u-4.
38. See Liu, supra note 28, at 116.
39. See Bundy, supra note 23, at 124.
40. Epstein, supra note 22, at 118–19.
2050 FORDHAM LAW REVIEW [Vol. 88
A. Separating Fraud from Fair Play
Legal MLM companies and illegal pyramid schemes both use a similarly
tiered organizational structure.
41
The following section describes the general
characteristics of MLM selling that may be present in both legal enterprises
and illegal pyramids. MLM selling is a subset of a larger universe of “direct
sales” models.
42
Direct sales companies sell products or services directly to
the end user, typically through independent distributors,
43
without using a
retailer.
44
MLM companies, in particular, tend to incentivize distributors to
recruit new participants by offering recruitment bonuses or commissions.
45
MLM companies almost invariably use an upline/downline structure.
46
Every member has a distributor above them and at least one below that they
have recruited into the plan.
47
The “upline” members earn both direct income
based on their own sales of goods or services and residual income from their
“downline” participants’ sales.
48
Thus, as a distributor’s downline grows,
with each downline participant recruiting his or her own downline members,
the upline receives commission from a greater number of sellers.
49
Accordingly, the company takes on a pyramid organizational shape through
geometric progression as more members are needed below to support the
income of members above.
50
Nonetheless, as discussed more thoroughly
below, not all MLM programs are illegal pyramid schemes.
51
41. Id. at 92.
42. Liu, supra note 28, at 111.
43. Participants in MLM companies may go by several different titles, including
consultants, owners, contractors, and distributors, despite performing substantially similar
functions. See Wesley K. Dagestaad, Note, Day’s Pyramid Ignores Sturdy Severability
Foundation, Builds off Granite Rock, 2014 J.
DISP. RESOL. 349, 349 n.2. Therefore, this Note
uses such terms interchangeably. Independent distributors differ from traditional retailers in
that distributors work for themselves and usually “set their own hours, create their own
marketing plans, determine whether to build a sales team and how to mentor those within it
and serve their customers.” What Is Direct Selling?, D
IRECT SELLING ASS’N,
https://dsa.org/about/direct-selling [https://perma.cc/M7MG-5RL6] (last visited Mar. 17,
2020).
44. See Peter J. Vander Nat & William W. Keep, Marketing Fraud: An Approach for
Differentiating Multilevel Marketing from Pyramid Schemes, 21 J.
PUB. POL’Y & MARKETING
139, 140 (2002).
45. Liu, supra note 28, at 111.
46. See Epstein, supra note 22, at 102–04.
47. Id. at 102.
48. Id. at 102–03.
49. Id. at 103. For a detailed description of a typical MLM reward system, see William
W. Keep & Peter J. Vander Nat, Multilevel Marketing and Pyramid Schemes in the United
States: An Historical Analysis, 6 J.
HIST. RES. MARKETING 188, 195 (2014).
50. For a diagram illustrating geometric progression in a sales-recruitment context, see
Vincent G. Ella, Comment, Multi-level or Pyramid Sales Systems: Fraud or Free Enterprise,
18 S.D.
L. REV. 358, 361 n.8 (1973).
51. Liu, supra note 28, at 115.
2020] HYBRID SECURITIES AND PYRAMID FRAUD 2051
1. Fair Play: Legal MLM Selling and Its Advantages
Legal MLM companies are commonly confused with, or categorized as,
illegal pyramid schemes because of organizational similarities.
52
Further,
there is no clear dividing line in the law that separates legitimate MLM
programs from illegal pyramid schemes.
53
Currently, there is no federal
statutory definition of an illegal pyramid scheme and the courts have been
inconsistent in how they distinguish pyramid schemes from MLM
companies, which exacerbates confusion.
54
Nonetheless, there are several
hallmarks of legitimate MLM businesses that set them apart from illegal
schemes.
The first, and arguably most important, hallmark is that legitimate MLM
companies focus primarily on real sales of marketable
55
products to real
consumers outside of the plan.
56
The FTC has broken this principle down
into four guideposts: (1) sales must be to real customers; (2) sales must be
profitable and verifiable; (3) program targets or thresholds should not be
satisfied by product purchases alone; and (4) compensation must be based on
genuine retail sales.
57
Second, legitimate MLM companies tend to accurately
represent the potential income or profits that their distributors can expect and
the degree of time or effort required to achieve success in the plans.
58
Further, legal MLM programs rarely require distributors to make minimum
inventory purchases to participate.
59
Finally, legitimate MLM programs
typically maintain a buyback policy through which the company will
repurchase inventory and sales kits from distributors wishing to leave the
program.
60
Legitimate MLM selling has benefits as a business model. For instance,
direct selling through multilevel channels has low fixed costs, particularly
52. See United States v. Gold Unlimited, Inc., 177 F.3d 472, 475 (6th Cir. 1999).
53. See Walsh, supra note 20, at 583.
54. Compare SEC v. Glenn W. Turner Enters. (Glenn Turner II), 474 F.2d 476 (9th Cir.
1973) (taking into account the mathematical probability of market saturation in finding the
scheme fraudulent), with Ger-Ro-Mar, Inc. v. FTC, 518 F.2d 33 (2d Cir. 1975) (noting the
mathematical impossibility that continuous recruitment could be sustained, yet declining to
conclude that the challenged scheme was deceptive).
55. Marketable products are those with competitive pricing and genuine demand in the
marketplace. Babener, supra note 18, at 24. Illegal pyramids masquerading as legitimate
MLM companies may sometimes claim substantial revenue from product sales, yet charge far
above reasonable retail value for such products. See, e.g., FTC v. BurnLounge, Inc., 753 F.3d
878, 883 (9th Cir. 2014).
56. See Ceresney, supra note 16.
57. Edith Ramirez, Chairwoman, Fed. Trade Comm’n, Keynote Remarks of FTC
Chairwoman Ramirez: DSA Business & Policy Conference 5–6 (Oct. 25, 2016),
https://www.ftc.gov/system/files/documents/public_statements/993473/ramirez_-
_dsa_speech_10-25-16.pdf [https://perma.cc/U752-AQNT].
58. Id.
59. Id.
60. Babener, supra note 18, at 24. But see Whole Living, Inc. v. Tolman, 344 F. Supp.
2d 739, 742 (D. Utah 2004) (finding an MLM company to be legitimate and legal despite the
absence of a buyback policy because its products were perishable and because the program’s
structure did not incentivize large purchases of inventory unrelated to demand for product).
2052 FORDHAM LAW REVIEW [Vol. 88
when compared to the price of operating traditional retail outlets.
61
Further,
in an MLM program, the existing sales force is responsible for training and
recruiting new participants.
62
The MLM model also emphasizes
entrepreneurship by encouraging social relationships between customers and
distributors, rewarding personal selling through commission, and offering
participants the independence and autonomy to build their own businesses
and “downline.”
63
Successful direct selling can be difficult because it
requires strong personal sales skills and a substantial investment of time and
social capital.
64
However, it does offer participants an opportunity to earn
supplemental income and, in rare cases, more substantial profit.
65
2. Fraud: Illegal Pyramid Schemes
In contrast to MLM companies, pyramid schemes are inherently
fraudulent.
66
The term “pyramid scheme” has both a broad and specific
meaning.
67
Broadly, a pyramid scheme is a kind of money-transfer
arrangement that relies on perpetual recruitment.
68
Each participant pays a
fee to enter the program and, in turn, receives the right to earn a portion of
the fees paid by those recruited below them.
69
However, “[a]s recruitment
continues, the number of people at or near the base of the recruitment
structure grows very rapidly, often at an exponential rate for as long as a
successful recruitment pattern is maintained.”
70
Accordingly, those at the
bottom struggle to recruit enough new members to recoup their investment.
71
Only the very few at the top earn a profit because the base necessarily
represents the vast majority of participants.
72
61. Vander Nat & Keep, supra note 44, at 140.
62. Id.
63. Id. Legitimate MLM distributors do earn a commission on sales of products by those
whom they have recruited or sponsored. However, such a structure does not, on its own,
render the program an illegal pyramid scheme. See Whole Living, 344 F. Supp. 2d at 745–46.
64. See Vander Nat & Keep, supra note 44, at 140–41.
65. See Ramirez, supra note 57, at 2–3.
66. Birdwell, supra note 22, at 561.
67. Keep & Vander Nat, supra note 49, at 196.
68. Id. The terms “pyramid scheme” and “Ponzi scheme” are often grouped together or
used interchangeably. See, e.g., Orlick v. Kozyack (In re Fin. Federated Title & Tr., Inc.), 309
F.3d 1325, 1327 (11th Cir. 2002). However, they are related, yet distinct concepts. See
Eberhard v. Marcu, 530 F.3d 122, 132 n.7 (2d Cir. 2008). Pyramid schemes funnel money to
participants by rewarding them for recruiting others, while Ponzi schemes pay initial investors
directly with money contributed by later investors. United States v. Gold Unlimited, Inc., 177
F.3d 472, 475 (6th Cir. 1999).
69. See Keep & Vander Nat, supra note 49, at 196–97.
70. Id.
71. See id.
72. Id. at 197; see also Koscot Interplanetary, Inc., 86 F.T.C. 1106, 1132–33, 1181 (1975)
(observing that an illegal pyramid scheme is really just an elaborate chain letter device in
which most individuals who hope to regain their initial payment are bound to be disappointed);
J. L. Gastwirth & P. K. Bhattacharya, Two Probability Models of Pyramid or Chain Letter
Schemes Demonstrating That Their Promotional Claims Are Unreliable, 32 O
PERATIONS RES.
527, 530 (1984) (reporting the statistical probabilities of expected returns for pyramid scheme
participants based on time of entry into the program).
2020] HYBRID SECURITIES AND PYRAMID FRAUD 2053
The specific definition of “pyramid scheme” is an organization that masks
a perpetual recruitment chain with the sale of a product or service through a
traditional MLM model.
73
However, in an MLM-based pyramid scheme,
while products are bought and sold by participants, compensation is still
derived chiefly from recruitment rather than market-based retail activity.
74
There are several consistent attributes of MLM-based pyramid schemes.
For instance, such schemes typically use a system of graduated product
prices.
75
In this system, each distributor purchases products at a lower price
than what he charges the public and what he charges if he sells to participants
below him in the distribution chain.
76
For example, a distributor at the lowest participant level, Distributor A,
may be entitled to purchase product from the parent company, for sale to the
public, at a 40 percent discount on the retail sales price.
77
However,
Distributor B, having achieved membership in the tier directly above
Distributor A, may be able to purchase product at a 55 percent discount.
78
Distributor B, further, has rights to sell both to the public and to Distributor
A. Distributor B, therefore, earns up to a 15 percent override on A’s sales
and may offer her customers a lower price for the product yet enjoy the same
profit margins as Distributor A.
79
As such, if both Distributors A and B operate in the same geographic or
social market, Distributor A is at a significant competitive disadvantage
because he must pay more for inventory. Accordingly, Distributor A has a
strong incentive to move up in the chain. If Distributor A rises in the
program, he will earn a larger wholesale discount along with the right to
recruit and sell to participants below him.
80
In such a system, therefore,
moving up in the scheme is the easiest and most effective way for Distributor
A to earn income.
81
These graduated price arrangements typically lead to another common
practice of MLM-based pyramid schemes known as inventory loading.
82
In
many illegal pyramids, participants may advance in the program solely by
73. Stacie Bosley & Maggie Knorr, Pyramids, Ponzis and Fraud Prevention: Lessons
from a Case Study, 25 J.
FIN. CRIME 81, 82 (2018); Keep & Vander Nat, supra note 49, at
196–97.
74. Bosley & Knorr, supra note 73, at 82; see also Koscot Interplanetary, 86 F.T.C. at
1181 (noting that the presence of “recruitment with rewards unrelated to product sales” is the
sine qua non of a pyramid scheme).
75. See Note, supra note 27, at 1258–59.
76. Id.
77. See Ella, supra note 50, at 362.
78. See id.
79. See id.
80. See id.
81. See id. at 362–63.
82. See Business Guidance Concerning Multi-level Marketing, F
ED. TRADE COMM’N,
https://ftc.gov/tips-advice/business-center/guidance/business-guidance-concerning-multi-
level-marketing [https://perma.cc/U9VD-CUUU] (last visited Mar. 17, 2020); see, e.g.,
Webster v. Omnitrition Int’l, Inc., 79 F.3d 776, 782–83 (9th Cir. 1996) (citing the scheme
participant’s testimony that distributors would purchase excessive quantities of product that
were entirely unrelated to actual market demand).
2054 FORDHAM LAW REVIEW [Vol. 88
meeting a threshold for minimum wholesale product purchases.
83
Distributor
A, for instance, may move up to the same tier as Distributor B by purchasing
a large quantity of inventory in bulk.
84
Importantly, in illegal schemes, there
is no requirement that Distributor A later prove that he has resold any product
to customers outside the program.
85
Rather, so long as Distributor A recruits
someone below him, Distributor C, then Distributor A has a built-in market
to offload the inventory to lower-level distributors at a profit.
86
Thus, the system encourages internal sales through continuous recruitment
and de-emphasizes sales to retail consumers outside of the plan.
87
As such,
MLM-based illegal pyramids use products predominantly to conceal the
fraud, and such products are frequently not competitive in a real-world
marketplace.
88
Rather, existing participants are compensated by money
coming in from new recruits and those below them in an endless-chain
fashion.
89
Expectedly, MLM-based pyramids must rely on the continuous enlistment
of new participants.
90
As such, the payment of bonuses upon successful
recruitment of a new member is another hallmark of such schemes.
91
These
payments are not based on the recruited distributors’ actual sales.
92
Instead,
they represent a predetermined percentage of the fee a new distributor must
pay or the cost of products they must purchase to enter the program.
93
83. See Ella, supra note 50, at 362.
84. See Babener, supra note 18, at 24–25.
85. See Omnitrition, 79 F.3d at 782 (describing rewards that are not tied to product sales
to end users because they are earned “based on the suggested retail price of the amount ordered
from Omnitrition, rather than based on actual sales to consumers”).
86. See id. (observing that lucrative rewards for recruitment induce participants to focus
on that part of the business, “making it unlikely that meaningful opportunities for retail sales
will occur” (citing Koscot Interplanetary, Inc., 86 F.T.C. 1106, 1132–33, 1181 (1975))). This
is one of the reasons why the FTC focuses so heavily on determining whether products are
sold principally to consumers outside of the program. Ramirez, supra note 57, at 5–10.
87. See Ramirez, supra note 57, at 6 (“When a product is tied to a business opportunity,
experience teaches that the people buying it may well be motivated by reasons other than
actual product demand.”).
88. See Ger-Ro-Mar, Inc., 84 F.T.C. 95, 148–49 (1974) (noting that the presence of some
retail sales does not impact the fundamentally unlawful character of pyramid schemes); see
also supra note 55 and accompanying text. A related problem arises when new distributors
are recruited so rapidly that supply outpaces demand to such a degree that most distributors
have virtually no chance of retailing products. See, e.g., People ex rel. Kelly v. Koscot
Interplanetary, Inc., 195 N.W.2d 43, 52–53 (Mich. Ct. App. 1972) (finding that for all plan
participants in Michigan to realize the promoters’ stated income projections, the company as
a whole would have needed to sell $300,000,000 worth of its cosmetics in that state in a year;
this figure was $20,000,000 more than the estimated total market demand for such goods in
the state).
89. Fast Answers: Pyramid Schemes, S
EC. & EXCHANGE COMMISSION (Oct. 9, 2013),
https://sec.gov/fast-answers/answerspyramidhtm.html [https://perma.cc/7V72-CDH2].
90. Babener, supra note 18, at 24.
91. Id.; Walsh, supra note 20, at 582 (observing that the most significant common
characteristic of all illegal pyramid schemes is payments in exchange for the right to recruit
others into the scheme).
92. See Keep & Vander Nat, supra note 49, at 198.
93. See id. at 196–97.
2020] HYBRID SECURITIES AND PYRAMID FRAUD 2055
B. Pyramid Fraud and the Harm to Consumers
As Part I.A demonstrated, the fundamental flaw in any pyramid scheme is
the inescapable reality that only a finite number of investors can ever recoup
their initial investments.
94
Pyramids are deliberately designed to grow
exponentially and rapidly.
95
When the schemes inevitably grow too large, it
becomes impossible to recruit enough new members to pay back existing
ones.
96
As a result, the large majority of participants lose money simply
because they enter the scheme after it has already become unsustainable.
97
Because pyramids require continuous recruitment, they employ
misrepresentations and unrealistic promises of success or potential
earnings.
98
First, the schemes intentionally use convoluted reward structures
and sale plans to mask the fraudulent nature of the program.
99
Second,
pyramid schemes frequently look very similar to legitimate MLM plans,
making it even more difficult for the average distributor to distinguish fraud
from fair play.
100
Third, pyramid schemes historically capitalize on potential participants’
lack of financial knowledge or expertise.
101
Scheme promoters often target
populations that are most susceptible to deceptive promises and those who
lack the necessary financial experience or expertise to identify the flaws in
the program.
102
For instance, communities or social networks with high
levels of underemployment and unemployment are particularly susceptible
to pyramid fraud victimization.
103
There is also a documented correlation
94. Gastwirth & Bhattacharya, supra note 72, at 528; Joseph P. Whitford, Note, Pyramid
Scheme Regulation: The Evolution of Investment Contracts as a Security Under the Federal
Securities Laws, 25 S
YRACUSE L. REV. 690, 694 (1974).
95. See Fast Answers: Pyramid Schemes, supra note 89.
96. See
id.
97. See id.
98. See Note, supra note 27, at 1259 (commenting on the widespread use of high-pressure
sales tactics, misleading presentations, and deceitful enthusiasm, which create an expectation
of dazzling financial returns in exchange for modest effort and time).
99. See Vander Nat & Keep, supra note 44, at 141.
100. See Lauren Bell, Pyramid Dream, B
ALT. MAG. (June 2018),
https://www.baltimoremagazine.com/2018/6/12/multi-level-marketing-companies-evolve-
with-21st-century [https://perma.cc/MNQ5-X2BE] (discussing the growth of the MLM
business, the allure of MLM selling, and the difficulty participants have in identifying and
assessing the risk that what appears to be a legitimate MLM company is in truth a pyramid
scheme); see also Bosley & Knorr, supra note 73, at 82 (noting the growth of more
sophisticated pyramid offerings set within the context of purportedly legitimate MLM
companies).
101. See Note, supra note 27, at 1261 (commenting that pyramid plans are aimed at the
general public and often employ recruitment tactics designed to make it difficult for potential
investors to come to intelligent or thoughtful decisions).
102. Whitford, supra note 94, at 694. But see Stacie A. Bosley et al., Decision-Making and
Vulnerability in a Pyramid Scheme Fraud, 80 J.
BEHAV. & EXPERIMENTAL ECON. 1, 5 (2019)
(reporting more recent data that may contradict the stereotype of fraud victims as older, less
sophisticated, and uneducated).
103. See Bosley & Knorr, supra note 73, at 84, 87; Stacie Bosley & Kim K. McKeage,
Multilevel Marketing Diffusion and the Risk of Pyramid Scheme Activity: The Case of Fortune
Hi-tech Marketing in Montana, 34 J.
PUB. POL’Y & MARKETING 84, 93 (2015) (finding that
counties in Montana with higher unemployment and greater economic contractions were more
2056 FORDHAM LAW REVIEW [Vol. 88
between lower levels of educational attainment and membership in pyramid
schemes.
104
The schemes also frequently appeal to those with fewer
opportunities in the mainstream job market
105
because the schemes are often
billed as a supplementary and flexible income source that require only a small
initial outlay of capital.
106
Fourth, because recruitment requires leveraging community ties and social
networks, there is significant overlap between affinity fraud and pyramid
fraud.
107
Affinity fraud “refers to investment scams that prey upon members
of identifiable groups, such as religious or ethnic communities, the elderly,
or professional groups.”
108
Such schemes can be particularly harmful to
individuals and communities because they exploit group trust, friendship,
and commonality.
109
Affinity fraud can also be especially difficult to detect
and stop because the close relationships among groups often make victims
reluctant to report the fraud or seek legal redress.
110
This problem is
particularly acute when scheme promoters have convinced respected group
members or community leaders to promote the fraud and encourage others to
join.
111
susceptible to recruitment efforts of a particular pyramid scheme); Ralph E. Stone & Jeffrey
M. Steiner, The Federal Trade Commission and Pyramid Sales Schemes, 15 P
AC. L.J. 879,
892 (1983) (noting that pyramid sales schemes are more popular during periods of economic
uncertainty).
104. Bosley & Knorr, supra note 73, at 90.
105. See id. at 84; Kathy Peiss, “Vital Industry” and Women’s Ventures: Conceptualizing
Gender in Twentieth Century Business History, 72 B
US. HIST. REV. 218, 235–36 (1998)
(discussing the ways that pyramid sales have appealed to working mothers as flexible job
opportunities).
106. See Bosley & Knorr, supra note 73, at 84.
107. See Lisa M. Fairfax, The Thin Line Between Love and Hate: Why Affinity-Based
Securities and Investment Fraud Constitutes a Hate Crime, 36 U.C.
DAVIS L. REV. 1073, 1082
(2003); Lisa M. Fairfax, “With Friends Like These . . .”: Toward a More Efficacious
Response to Affinity-Based Securities and Investment Fraud, 36 G
A. L. REV. 63, 72 (2001).
Even where affinity groups are not involved, the importance of social networking, combined
with the high-pressure sales and recruiting tactics typical of direct selling, may make
distributors reluctant to leave programs even when they have incurred substantial financial
losses. See, e.g., Amelia Tait, ‘They Have You in a Cultish Grip’: The Women Losing
Thousands to Online Beauty Schemes, G
UARDIAN (June 1, 2019),
https://theguardian.com/fashion/2019/jun/01/online-beauty-schemes-selling-social-media-
younique-arbonne [https://perma.cc/EV3H-P2R7].
108. Affinity Fraud: How to Avoid Investment Scams That Target Groups, S
EC. &
EXCHANGE COMMISSION (Oct. 9, 2013), https://www.sec.gov/investor/pubs/affinity.htm
[https://perma.cc/TDR6-MEDC] (noting that affinity scams frequently involve Ponzi or
pyramid schemes).
109. Investor Alert: Affinity Fraud, S
EC. & EXCHANGE COMMISSION (June 18, 2014),
https://www.sec.gov/oiea/investor-alerts-bulletins/ia_affinityfraud.html
[https://perma.cc/4JBM-HSYP]; see also David E. Austin, Comment, “In God We Trust”:
The Cultural and Social Impact of Affinity Fraud in the African American Church, 4 U.
MD.
L.J. RACE RELIGION GENDER & CLASS 365, 365 (2004) (observing that affinity fraud can be
especially effective among minority groups with a documented history of oppression, such as
the African-American community, because the trust implicit among members is often
particularly strong when the group has experienced social marginalization).
110. Investor Alert: Affinity Fraud, supra note 109.
111. Id.
2020] HYBRID SECURITIES AND PYRAMID FRAUD 2057
Several factors complicate enforcement and prevention, making it difficult
to gauge the precise amount of money that victims in the United States lose
to pyramid schemes each year.
112
Settlements with both the FTC and SEC
commonly reach tens of millions of dollars.
113
Additionally, the FTC’s most
recent survey indicates that around 1.5 million people fall victim to pyramid
scheme fraud in the United States in any given year.
114
Unfortunately, of all
monitored consumer fraud victim groups, pyramid scheme victims are the
least likely to make formal reports to government authorities.
115
This may
be because, when compared to Ponzi schemes—in which there are usually
fewer victims who each lose larger sums
116
—pyramids tend to involve a
greater number of victims who each lose a smaller amount.
117
There is also
evidence that pyramid promoters stigmatize those who leave the program,
announcing that participants who fail do so because of a lack of skill or
dedication.
118
Finally, researchers have identified that guilt is a strong
deterrent to victim reporting, a phenomenon that is unique to pyramid scheme
fraud.
119
As participants feel regret and embarrassment for bringing in
friends, family members, or colleagues, they are less likely to speak up about
the experience.
120
Because of such low reporting rates and high social
connectivity among pyramid scheme victim groups, prevention and
enforcement are particularly important in this area.
121
112. See Keep & Vander Nat, supra note 49, at 203–05 (noting the dearth of verifiable data
regarding MLM and pyramid sales).
113. See Terrell McSweeney, Congress Should Crack Down on Predatory ‘Pyramid
Schemes,’ Not Look Away, H
ILL (Aug. 3, 2017, 8:00 AM), https://thehill.com/blogs/pundits-
blog/finance/345073-congress-should-crack-down-on-predatory-pyramid-schemes-not-look
[https://perma.cc/WJL7-68NA] (reporting two FTC settlements with Herbalife and Fortune
Hi-Tech Marketing totaling a combined $210 million and the $17 million lost by victims of
the BurnLounge scheme).
114. F
ED. TRADE COMM’N, CONSUMER FRAUD IN THE UNITED STATES, 2011: THE THIRD
FTC SURVEY 18–19 (2013), https://www.ftc.gov/sites/default/files/documents/reports/
consumer-fraud-united-states-2011-third-ftc-survey/130419fraudsurvey_0.pdf
[https://perma.cc/22AR-BE3S].
115. Bosley et al., supra note 102, at 1–2.
116. See, e.g., Scott Cohn, Want to Work at Home?: Take a Lesson from This $3 Billion
Pyramid Scheme, CNBC (June 22, 2018, 8:00 AM), https://www.cnbc.com/2018/06/21/want-
to-work-at-home-take-a-lesson-from-this-3-billion-pyramid-scam.html
[https://perma.cc/A9JV-LTTT] (comparing the TelexFree pyramid scheme, which defrauded
an estimated 1.8 billion victims worldwide out of $3 billion, with Bernie Madoff’s Ponzi
scheme, which victimized several thousand people but generated $17.5 billion in losses).
117. See F
ED. TRADE COMM’N, supra note 114, at 39 (reporting that 50 percent of pyramid
scheme victims who provided information on payments reported paying at least $200).
118. See Bosley et al., supra note 102, at 11.
119. Id. (“This last factor is unique to pyramid scheme fraud as it is the only form of fraud
that, by definition, incentivizes person-to-person recruitment.”).
120. See Bosley & Knorr, supra note 73, at 83.
121. See Bosley et al., supra note 102, at 2.
2058 FORDHAM LAW REVIEW [Vol. 88
C. The Landscape of Existing Laws and Regulations
Hundreds of thousands of Americans participate in MLM-based direct
sales every year.
122
While many work within legitimate MLM companies, a
great number of people unknowingly sign up for illegal pyramids.
123
The
overwhelming majority of these people lose money in the process.
124
Both
state and federal agencies have worked hard to educate the public on how to
spot and avoid fraudulent schemes.
125
However, it is difficult for the public
to identify fraudulent programs effectively when government actors
themselves have trouble separating the legitimate from the illegal.
126
As a
result, government intervention has focused more on detection of, and
enforcement against, illegal pyramids.
127
However, one of the reasons pyramid schemes are so difficult to detect and
stamp out is that they exist in a legal gray area.
128
On the federal level, MLM
programs—both the legitimate enterprises and MLM-based pyramids—fall
outside the FTC’s definition of a franchise.
129
Accordingly franchise
regulations and disclosure requirements do not apply to pyramids.
130
Moreover, as discussed more thoroughly below,
131
FTC enforcement actions
charging unfair and deceptive practices have thus far not proved especially
effective at deterring pyramid scheme formation.
132
Further, with the
exception of the Ninth Circuit,
133
the federal courts have been unwilling to
122. See Direct Selling in the United States: 2018 Industry Overview, DIRECT SELLING
ASS’N 1, https://www.dsa.org/docs/default-source/action-alerts/2018industryoverview-
06032019.pdf [https://perma.cc/TEC7-Q7QW] (last visited Mar. 17, 2020).
123. Pareja, supra note 26, at 84–85.
124. F
ED. TRADE COMM’N, supra note 114, at 13 (reporting that often 90 percent or more
of participants in pyramid schemes do not recoup their initial investment).
125. See, e.g., Business Guidance Concerning Multi-level Marketing,
supra note 82; Dana
Nessel, Consumer Alert: Multi-level Marketing or Illegal Pyramid Scheme?, M
ICH. ATT’Y
GEN., https://www.michigan.gov/ag/0,4534, 7-164-177337_20942-208400--,00.html
[https://perma.cc/PZ34-BFDX] (last visited Mar. 17, 2020).
126. See Walsh, supra note 20, at 583 (noting that courts, legislators, and enforcement
agencies have all struggled to adequately define the term “pyramid scheme”).
127. See Note, supra note 27, at 1266, 1274.
128. See Bosley & Knorr, supra note 73, at 81 (explaining that pyramid schemes operate
in a complicated practical and legal environment); Walsh, supra note 20, at 583.
129. See Business Opportunity Rule, 76 Fed. Reg. 76,816 (Dec. 8, 2011) (to be codified at
16 C.F.R. pt. 437) (noting that because of the minimum investment and inventory exemptions
to the franchise rule, pyramid schemes are not covered); W. M
ICHAEL GARNER, FRANCHISE
AND
DISTRIBUTION LAW AND PRACTICE § 1.11 (2019) (noting that sales distributorships differ
from franchises in that (1) distributors do not pay franchise fees for the right to resell a product
or use the trademark of a supplier; (2) the supplier in a distributorship will rarely provide a
marketing system or plan; and (3) the distributor has no rights to the supplier’s trademark).
130. See Business Guidance Concerning Multi-level Marketing, supra note 82, ¶ 10.
131. See infra Part I.C.2.
132. See Pareja, supra note 26, at 94–97 (noting the difficulty in gathering evidence of
unfair or deceptive acts and reporting that, between January 1997 and December 2005,
consumers submitted 17,858 complaints regarding pyramid schemes but the FTC only brought
twenty cases against such schemes under the FTCA between 1990 and 2008).
133. See Glenn Turner II, 474 F.2d 476, 479 (9th Cir. 1973).
2020] HYBRID SECURITIES AND PYRAMID FRAUD 2059
hold that pyramid schemes are per se securities.
134
Moreover, state-level
regulation has been problematic for two reasons. First, predatory pyramid
schemes are able to move easily across state lines to avoid disclosure
requirements or limit liability in future enforcement actions.
135
Second, for
legal MLM companies, inconsistent state laws and regulatory regimes
complicate risk assessment, and this unpredictability may discourage the
growth of legitimate businesses.
136
1. The States
Though there is no federal antipyramid scheme statute, many states have
passed laws targeting pyramid schemes and other kinds of chain promotion
or distribution plans.
137
Typically, state statutes either target pyramids
specifically or handle them within broader statutes prohibiting deceptive
trade practices.
138
These laws vary greatly, as do the individual state
definitions of the term “pyramid scheme.”
139
However, many states do at
least prohibit the sale of business opportunities
140
unless the seller provides
the prospective participant with a presale disclosure document that has been
filed with the relevant state agency.
141
Nonetheless, twenty-one states have
antipyramid scheme laws that define pyramid fraud and distinguish the
practices of such schemes from those of legitimate businesses.
142
134. See, e.g., Davis v. AVCO Fin. Servs., Inc., 739 F.2d 1057 (6th Cir. 1984); Ranieri v.
AdvoCare Int’l, L.P., 336 F. Supp. 3d 701, 713–14 (N.D. Tex. 2018); Kerrigan v. ViSalus,
Inc., 112 F. Supp. 3d 580, 598–99 (E.D. Mich. 2015).
135. Note, supra note 27, at 1265.
136. See id. at 1257, 1265–66.
137. Epstein, supra note 22, at 118–19. For decades, commentators have called on
Congress to pass a specific antipyramid statute. See, e.g., Ella, supra note 50, at 392–93; Note,
supra note 27, at 1293. Further, proposed antipyramid legislation has been introduced in the
U.S. Senate twice but has never successfully passed. Valentine, supra note 20. This may be
the result of difficulty in crafting an appropriate definition for illegal pyramid schemes that is
both precisely targeted but not excessively narrow so as to encourage circumvention. See infra
note 150 and accompanying text.
138. D
EE PRIDGEN & RICHARD M. ALDERMAN, CONSUMER PROTECTION AND THE LAW
§ 3.14 (2019–2020 ed.).
139. Compare C
AL. PENAL CODE § 327 (West 2020) (prohibiting “[a]ny scheme for the
disposal or distribution of property whereby a participant pays a valuable consideration for the
chance to receive compensation for introducing one or more additional persons into
participation in the scheme”), with M
ICH. COMP. LAWS § 445.2582(h) (2020) (“‘Pyramid
promotional scheme’ means any plan or operation in which an individual gives consideration
for the opportunity to receive compensation that is derived primarily from recruiting other
individuals into the plan or operation rather than from the sale of products or services to
ultimate users or from the consumption or use of products or services by ultimate users.”).
140. Federal and state authorities both similarly define a business opportunity as an
“arrangement[] where a seller solicits a prospective buyer to enter into a business, the
prospective purchaser makes a required payment, and the seller—expressly or by
implication—makes certain kinds of claims.” Selling a Work-at-Home or Other Business
Opportunity?: Revised Rule May Apply to You, F
ED. TRADE COMMISSION (Nov. 2011),
https://www.ftc.gov/tips-advice/business-center/guidance/selling-work-home-or-other-
business-opportunity-revised-rule [https://perma.cc/BZP7-GV7K].
141. Pareja, supra note 26, at 105.
142. Sean Reyes, Learning from the States: Feds Should Adopt Anti-pyramid Scheme Law,
HILL (Nov. 19, 2017, 12:30 PM), https://thehill.com/blogs/congress-blog/judicial/362235-
2060 FORDHAM LAW REVIEW [Vol. 88
Additionally, all fifty states have their own securities laws,
143
under which
state regulators have targeted pyramid schemes for securities fraud or
violations of state disclosure provisions.
144
However, enforcing state laws against multistate companies is difficult
because these laws vary widely.
145
As a result, companies that might face
greater liability or disclosure requirements in one state may easily transfer
their operations across borders.
146
This is particularly true given the
increasing role of technology and the internet in pyramid scheme
promotion.
147
Further, variation among state antipyramid statutes and
business opportunity laws has produced an uncoordinated regulatory
effort.
148
For legitimate MLM programs, this inconsistency creates
unpredictability and discourages the growth of economically productive
businesses.
149
Finally, state statutes that narrowly define the term “pyramid
scheme” may unwittingly provide a roadmap that allows promoters to design
programs that specifically skirt the definition.
150
Use of state securities laws against pyramids is similarly difficult.
151
The
variation that weakens antipyramid statutes as regulatory tools similarly
reduces the efficacy of state securities laws in this area.
152
Furthermore, in
1996, the National Securities Markets Improvement Act of 1996
153
(NSMIA)
explicitly preempted state securities laws in many ways.
154
For instance,
NSMIA barred the states from imposing registration or reporting
requirements on issuers of covered securities.
155
Subsequently, the
learning-from-the-states-feds-should-adopt-anti-pyramid-scheme [https://perma.cc/SB97-
GJ9Y].
143. Adam J. Gana & Michael Villacres, Blue Skies for America in the Securities
Industry . . . Except for New York: New York’s Martin Act and the Private Right of Action, 19
F
ORDHAM J. CORP. & FIN. L. 587, 596 (2014).
144. See Liu, supra note 28, at 116.
145. Pareja, supra note 26, at 104.
146. Id.
147. See Valentine, supra note 20.
148. See Epstein, supra note 22, at 118; Stone, supra note 103, at 893–94; see also Eric
Witiw, Selling the Right to Sell the Same Right to Sell: Applying the Consumer Fraud Act,
the Uniform Securities Law and the Criminal Code to Pyramid Schemes, 26 S
ETON HALL L.
REV. 1635, 1643–44 (1996).
149. See Howie, supra note 23, at 289–90 (noting the ambiguity and uncertainty in the
application of various state statutes to multilevel marketing plans).
150. See C
AROLYN L. CARTER, CONSUMER PROTECTION IN THE STATES: A 50-STATE
REPORT ON UNFAIR AND DECEPTIVE ACTS AND PRACTICES STATUTES 11 (2009),
https://www.nclc.org/images/pdf/udap/report_50_states.pdf [https://perma.cc/R75W-7MC8];
Frank Mays Hull, Comment, Pyramid Marketing Plans and Consumer Protection: State and
Federal Regulation, 21
J. PUB. L. 445, 454 (1972).
151. Pareja, supra note 26, at 104–05.
152. See Witiw, supra note 148, at 1640–42.
153. Pub. L. No. 104-290, 110 Stat. 3416 (codified as amended in scattered sections of 15
and 29 U.S.C.).
154. 15 U.S.C. § 77r (2018); T
HOMAS LEE HAZEN, TREATISE ON THE LAW OF SECURITIES
REGULATION § 1.24 (7th ed. 2019).
155. 15 U.S.C. § 77r.
2020] HYBRID SECURITIES AND PYRAMID FRAUD 2061
Securities Litigation Uniform Standards Act of 1998
156
also removed most
securities class actions involving publicly traded securities from state
courts.
157
Moreover, even where these statutes do not explicitly preempt
state law, courts have frequently held that state laws that conflict with federal
securities law may be impliedly preempted.
158
Accordingly, states currently
play a greatly diminished role in securities regulation and enforcement.
159
In
sum, while state-level regulation may be useful for targeting localized
pyramid fraud within state borders, on the whole, it is not a particularly
effective tool for combatting this national problem.
2. The FTC
On the federal level, the FTC began robust enforcement against pyramids
in the 1970s, when modern MLM companies began to take shape and
proliferate.
160
Two important cases, Koscot Interplanetary, Inc.
161
and
Amway Corp.,
162
helped develop the criteria that the FTC would use to define
illegal pyramid schemes and to distinguish them from legitimate MLM
programs.
163
In Koscot, the FTC alleged that the company’s realization of profit was
predicated upon inducing others, through misrepresentations of potential
profits, to join the plan.
164
However, due to high market saturation and
exceedingly low market demand for the actual products, those who joined
after the first few rounds of recruitment were all but guaranteed to lose any
money they had invested in purchasing the products for resale.
165
The FTC successfully showed that Koscot’s business model was false,
misleading, and deceptive, and therefore it constituted an unfair act and
practice.
166
The administrative law judge thus held that unlawful pyramids
are characterized by payments by participants “in return for which they
receive (1) the right to sell a product and (2) the right to receive in return for
recruiting other participants into the program rewards which are unrelated to
156. Pub. L. No. 105-353, 112 Stat. 3227 (codified as amended in scattered sections of 15
U.S.C.).
157. H
AZEN, supra note 154, § 1.24.
158. Id.
159. See Rutherford B. Campbell, Jr., The Role of Blue Sky Laws After NSMIA and the
JOBS Act, 66 D
UKE L.J. 605, 613–14 (2016). State regulation may nonetheless still be useful
for more localized fraud, and states still retain some jurisdiction over certain securities actions.
H
AZEN, supra note 154, § 1.24. For instance, class actions implicating securities that are not
publicly traded may still be heard in state court. Id.
160. Jessica Sweeb, Health Multi-level Marketing: Robbing People of Their Money and
Their Health, 27
ANNALS HEALTH L. ADVANCE DIRECTIVE 223, 228 (2018).
161. 86 F.T.C. 1106 (1975).
162. 93 F.T.C. 618 (1979).
163. Sweeb, supra note 160, at 228–30.
164. Koscot, 86 F.T.C. at 1112.
165. Id.
166. Id.
2062 FORDHAM LAW REVIEW [Vol. 88
the sale of the product to ultimate users.”
167
The FTC continues to use this
definition today.
168
In stating that the program was not a pyramid and did not engage in
deceptive business practices, the Amway decision provided guideposts for
distinguishing between illegal pyramids and legitimate MLM programs.
169
The decision emphasized three of Amway’s company policies and concluded
that such policies provided sufficient consumer protection safeguards. First,
Amway had a policy of buying back goods of distributors leaving the
program.
170
Second, Amway required that distributors make sales to at least
ten unique customers each month.
171
And third, distributors were required
to sell 70 percent of the product they purchased each month to customers
outside the Amway program.
172
In the years since Amway, those three policies have become known as the
Amway safeguards rule.
173
Legitimate MLM companies have generally
been able to limit much of their potential FTC liability by incorporating
Amway’s policies into their business models.
174
The FTC’s regulatory
approach to pyramid schemes has also remained consistent in the decades
since Koscot and Amway.
175
The agency continues to rely heavily—if not
exclusively—on case-by-case adjudication and enforcement.
176
Though the FTC has had some success in taking down large pyramid
schemes, several major obstacles prevent effective FTC regulation and
enforcement. First, shutting down a scheme under the Federal Trade
Commission Act of 1914 is difficult, time-consuming, and costly.
177
Proving, for instance, that a company affirmatively misrepresented its
earning potential is a highly fact-intensive process that requires significant
agency resources.
178
Moreover, pyramids and fraudsters have proven
capable of adapting and innovating to evade detection, which has made the
FTC’s cases even harder to prove.
179
Additionally, by the time pyramid
schemes achieve the size and visibility necessary to attract FTC attention,
167. Id. at 1180.
168. See Business Guidance Concerning Multi-level Marketing, supra note 82.
169. See Amway Corp., 93 F.T.C. 618 (1979).
170. Pareja, supra note 26, at 95.
171. Id.
172. Id.
173. Babener, supra note 18, at 24.
174. See id.
175. See Pareja, supra note 26, at 88–90.
176. See Business Guidance Concerning Multi-level Marketing, supra note 82 (explaining
that the commission engages in case-by-case enforcement and adjudication, rather than
prescriptive rulemaking).
177. Walsh, supra note 20, at 588.
178. See Note, supra note 27, at 1272 n.99; see also Pareja, supra note 26, at 95–96
(explaining that companies are careful to protect against claims of misrepresentation by
trumpeting the success of the few at the top of the pyramid while including generic and bare
disclaimers); Walsh, supra note 20, at 591 (observing that FTC adjudication requires “lengthy
and complicated factual analyses that use balancing tests, percentages, and somewhat arbitrary
ratios”).
179. See FTC v. BurnLounge, Inc., 753 F.3d 878, 883 (9th Cir. 2014) (citing the district
court’s description of the BurnLounge bonus system as a “labyrinth of obfuscation”).
2020] HYBRID SECURITIES AND PYRAMID FRAUD 2063
most stakeholders have already incurred significant losses that they are
unlikely to recoup.
180
Finally, the FTC only has the authority to bring civil charges against
pyramid operators.
181
Accordingly, the consequences of FTC violations,
though sometimes significant, are limited to financial loss.
182
Because
enforcement actions are lengthy and not guaranteed,
183
the overall deterrent
effect of FTC enforcement has been somewhat weak.
184
3. The SEC
The SEC became concerned about pyramid schemes around the same time
that the FTC did.
185
In November 1971, the agency issued a landmark
release, which detailed its view that the operation of a pyramid scheme may
involve the offering of a security under the Securities Act of 1933.
186
Where
pyramid schemes are classified as securities, there are several important
consequences.
187
First, promoters of pyramid securities are required to
register any agreement between the company and potential investors with the
SEC.
188
Second, investors recruiting or soliciting others in exchange for a
commission or other compensation need to be brokers, as defined by the 1934
Securities Exchange Act.
189
Third, deceptive acts or practices connected to
the sale or offer to participate are subject to securities antifraud provisions.
190
Further, under the ambit of the federal securities laws, pyramid profits may
be subject to disgorgement.
191
Although the SEC has no authority to require
a violator of the securities laws to make restitution, in injunction actions, the
agency has frequently been successful in securing orders requiring
disgorgement of profits as ancillary relief.
192
These funds are then held in a
depository and distributed to victims entitled to recovery.
193
The SEC may
180. See FTC Action Leads Court to Halt Alleged Pyramid Scheme, FED. TRADE
COMMISSION (Jan. 28, 2013), https://www.ftc.gov/news-events/press-releases/2013/01/ftc-
action-leads-court-halt-alleged-pyramid-scheme [https://perma.cc/XLE8-2576] (reporting
that, by the time the FTC’s complaint was filed, more than 100,000 consumers had been
victimized by the scheme and more than 90 percent of those who bought in had lost their
money).
181. See 15 U.S.C. § 45 (2018).
182. See id.
183. See supra note 132 and accompanying text.
184. See Matt Stroud, An Insider Explains Why the FTC Can’t Put an End to Pyramid
Schemes, B
LOOMBERG (Feb. 27, 2015, 1:39 PM), http://bloomberg.com/news/articles/2015-
02-27/an-insider-explains-why-the-ftc-can-t-put-an-end-to-pyramid-schemes
[https://perma.cc/YKS8-LXY8].
185. See Bundy, supra note 23, at 128.
186. Multi-level Distributorships and Pyramid Sales Plans, Securities Act Release No.
5211, Exchange Act Release No. 9387, 36 Fed. Reg. 23,289 (Nov. 30, 1971) [hereinafter
Release].
187. See Bundy, supra note 23, at 129.
188. See 15 U.S.C. § 77e (2018).
189. See id. § 78c.
190. See id. § 77x.
191. See H
AZEN, supra note 154, § 1.55.
192. Id.
193. Id.
2064 FORDHAM LAW REVIEW [Vol. 88
also issue disgorgement orders against securities violators.
194
The
application of these regulatory tools is, however, necessarily dependent upon
pyramid schemes meeting the federal definition of “security.”
195
The history and background of the federal securities regime offer useful
context for examining the interpretation and application of the federal
securities laws to pyramid schemes. Federal securities regulation emerged
in the wake of the infamous stock market crash of 1929.
196
In this period,
Congress was particularly concerned that, due to unchecked fraud, investors
had been duped into funneling money into spurious companies.
197
In
response, it used state “blue sky laws”
198
as a model for a federal securities
regime.
199
With the aim of protecting the investing public, Congress devised a broad
statutory definition for a security, which covers a variety of financial
instruments and investment opportunities.
200
Accordingly, the U.S. Supreme
Court construed the term “security” within the 1933 Securities Act to
“include by name or description many documents in which there is a common
trading for speculation or investment.”
201
The Court recognized that some
instruments, such as notes, bonds, and stocks, have well-settled meaning.
202
However, descriptive designations or catchall terms, such as “investment
contract,” may reach “novel, uncommon, or irregular devices” so long as the
device generally involves a contribution of capital with the intention to earn
income or profit from its use.
203
Though pyramid schemes do not fall within the meanings of any of the
well-settled statutory terms such as “stock” or “bond,” the SEC has argued
that pyramids are securities because they constitute investment contracts.
204
However, the term “investment contract,” though included in the statutory
list of instruments that may be securities, is not defined by statute.
205
Therefore, in SEC v. W.J. Howey & Co.,
206
the Supreme Court articulated a
test for determining whether an investment contract exists within the
194. Id.
195. Bundy, supra note 23, at 124.
196. Ryan C. Farha, Comment, SEC v. Edwards: An Opportunity to Knock on the Viability
of the Howey Test as the Gatekeeper of Federal Securities Laws, 31 O
KLA. CITY U. L. REV.
161, 165 (2006).
197. See Farha, supra note 196, at 165.
198. The term “blue sky laws” refers to state statutes regulating securities markets. Gregory
J. Pease, Note, Bluer Skies in Tennessee—the Recent Broadening of the Definition of
Investment Contract as a Security and an Argument for a Unified Federal-State Definition of
Investment Contract, 35 U.
MEM. L. REV. 109, 111–12 (2004).
199. David K. Brown & Valerie D. Barton, Securities Regulation, 56 MERCER L. REV.
1341, 1352 (2005).
200. See Pareja, supra note 26, at 97–103.
201. SEC v. C.M. Joiner Leasing Corp., 320 U.S. 344, 351 (1943).
202. Id.
203. SEC v. W.J. Howey & Co., 328 U.S. 293, 299 (1946) (“It embodies a flexible rather
than static principle, one that is capable of adaptation to meet the countless and variable
schemes devised by those who seek the use of the money of others on the promise of profits.”).
204. Release, supra note 186, at 23,289.
205. See Brown & Barton, supra note 199, at 1352–53.
206. 328 U.S. 293 (1946).
2020] HYBRID SECURITIES AND PYRAMID FRAUD 2065
meaning of the federal securities laws.
207
The Court held that “an investment
contract for purposes of the Securities Act means a contract, transaction, or
scheme whereby a person,” (1) “invests his money,” (2) “in a common
enterprise,” and (3) “is led to expect profits solely from the efforts of the
promoter or a third party.”
208
The Howey Court emphasized the need for flexibility in interpreting the
term “investment contract” to ensure that the federal securities laws fulfilled
their purpose of generously protecting investors.
209
For instance, the Court
approved of the prevailing state court approach, which disregarded form for
substance and emphasized economic reality.
210
Moreover, the Court noted
that the federal securities regime was based on states’ blue sky laws.
211
Therefore, the Court reasoned that Congress intended that the term
“investment contract,” under federal law, be given the same well-settled and
flexible meaning it had under state laws.
212
Such state laws were primarily
concerned with protecting investors from fraudulent securities schemes, not
with precisely demarcating all possible variations that might arise in capital
markets.
213
As discussed more thoroughly below, the SEC has had varying success
convincing courts that pyramids involve the sale of securities. Nonetheless,
the SEC does regularly bring enforcement actions against pyramids,
primarily alleging the use of materially false or misleading statements.
214
II.
WHEN A PYRAMID IS ALSO A SECURITY: DIFFERENT TESTS FOR
FINDING AN “INVESTMENT CONTRACT”
When courts find that a pyramid involved the sale of securities, a variety
of new enforcement mechanisms become available.
215
First, the scheme’s
top-level promoters may face liability for the sale of unregistered
securities
216
or for material misrepresentations and omissions in the sale of
such securities.
217
Further, as material misrepresentations constitute fraud,
individuals may be subject to criminal liability under federal mail and wire
fraud statutes.
218
Finally, classification as a security allows defrauded
scheme participants to bring private actions against the pyramid’s promoters
207. Id. at 299.
208. Id. at 298–99.
209. Id. at 301.
210. Id. at 298.
211. Id.
212. Id.; see also Brown & Barton, supra note 199, at 1352 (noting that Congress looked
to the blue sky laws when drafting federal securities law in order to build an adaptable body
of law that would protect the public).
213. See Farha, supra note 196, at 165.
214. See Pareja, supra note 26, at 96–97.
215. See supra Part I.C.3.
216. See 15 U.S.C. §§ 77e, 77l (2018).
217. See id. § 77x; 17 C.F.R. § 240.10b-5 (2019).
218. See 18 U.S.C. §§ 1341, 1343 (2018).
2066 FORDHAM LAW REVIEW [Vol. 88
and organizers under the PSLRA.
219
Such penalties represent significant
deterrents to the formation and operation of pyramid schemes.
220
The enforcement mechanisms available under federal securities law,
however, are not available in every case because the courts have employed
inconsistent reasoning when determining the existence of an investment
contract.
221
As explained above, the Howey test is the definitive rule for
identifying an investment contract within the meaning of the federal
securities laws.
222
On the state level, however, the risk capital approach has
developed as an alternative to the Howey test.
223
Part II illustrates the
development of these two different tests and the application of each test to
pyramid schemes alleged to be securities.
A. Application of the Howey Test to Pyramid Schemes
For pyramid schemes, the third prong of Howey is usually the most
difficult to satisfy.
224
The third prong asks whether the investor expected
that profits would be derived “solely from the efforts of the promoter or a
third party.”
225
In the wake of Howey, some commentators noted that the use
of the word “solely” was problematic because it provided a means for
avoiding literal application of the test.
226
Because the Howey test ostensibly
failed to protect investors who contributed a modicum of effort, schemes
could implement a requirement of nominal participation and thus avoid
securities laws.
227
219. See 15 U.S.C. § 78u-4.
220. Spencer M. Reese, Securities Law & MLM—What’s the Deal?, R
EESE POYFAIR
RICHARDS PLLC (Sept. 24, 2018), https://www.mlmlaw.com/law-library/securities-law-and-
mlm-whats-the-deal [https://perma.cc/SG28-X8AE].
221. See infra Part II.A.
222. See infra Part II.A.
223. See infra Part II.B.
224. See Pareja, supra note 26, at 99–100; Note, supra note 27, at 1277. See generally
Bundy, supra note 23. On rare occasions, pyramid schemes have failed to satisfy the
“common enterprise” prong. See, e.g., United States v. Holtzclaw, 950 F. Supp. 1306, 1314–
16 (S.D.W. Va. 1997). However, a discussion of the commonality element is unnecessary
here because the federal courts overwhelmingly find that pyramid schemes satisfy this
requirement. Pareja, supra note 26, at 99. For a thorough discussion of the common enterprise
element and the split among courts as to its application, see Maura K. Monaghan, Note, An
Uncommon State of Confusion: The Common Enterprise Element of Investment Contract
Analysis, 63 F
ORDHAM L. REV. 2135 (1995).
225. SEC v. W.J. Howey & Co., 328 U.S. 293, 299 (1946).
226. See Kyle M. Globerman, Casenote, The Elusive and Changing Definition of a
Security: One Test Fits All, 51
FLA. L. REV. 271, 290 (1999); Note, supra note 27, at 1277–
78 (arguing that the Howey Company could have required each investor to pick a single orange
and thereby avoided literal application of the test).
227. See Note, supra note 27, at 1277–78.
2020] HYBRID SECURITIES AND PYRAMID FRAUD 2067
1. Liberalization of Howey’s “Efforts of Others” Prong
In the years after Howey, several lower courts lessened the restrictiveness
of the third prong of the test.
228
In SEC v. Glenn W. Turner Enterprises, Inc.
(Glenn Turner I),
229
the SEC brought suit against Glenn Turner’s company,
Dare to Be Great, which sold self-improvement courses through MLM
distribution.
230
The company defendants argued that the third prong of
Howey was not met.
231
They pointed to the fact that at the initial sales
meetings for the program, investors were given the opportunity to recruit
others and were told of the importance of their efforts.
232
Accordingly, the
defendants asserted, participants were not led to expect that profits would
flow solely from the efforts of others.
233
The court, nonetheless, found that the scheme constituted an investment
contract for three reasons. First, any business skills an investor may have
had were far less important than his or her ability to pay for the plan.
234
Second, the investor’s primary, if not sole, responsibility was to bring new
people to attend recruitment meetings.
235
Third, the success or failure of the
program was entirely dependent on the business decisions of the high-level
company managers.
236
In sum, because the company and its top-level
organizers, not the individual participants, performed the essential
managerial tasks, the court concluded that Turner’s plan constituted an
investment contract.
237
In its analysis, the Glenn Turner I court approved of the approach
developed by the California Supreme Court in Silver Hills Country Club v.
Sobieski.
238
In Silver Hills, the state court focused on the economic reality
of a security, finding that fundamentally, a security involves “investors [who]
subject their money to the risk of an enterprise over which they exercise no
managerial control.”
239
The Glenn Turner I court reasoned, in the same vein,
that because the parent company ultimately remained responsible for all
managerial decisions and responsibilities, the investor-participants were
entitled to the protections of the federal securities law.
240
The Ninth Circuit affirmed, holding that Dare to Be Great indeed offered
investment contracts under a properly liberal reading of the Howey test.
241
228. See Douglas M. Branson & Karl Shumpei Okamoto, The Supreme Court’s Literalism
and the Definition of “Security” in the State Courts, 50 W
ASH. & LEE L. REV. 1043, 1050
(1993).
229. 348 F. Supp. 766 (D. Or. 1972), aff’d, 474 F.2d 476 (9th Cir. 1973).
230. Id.
231. Id. at 770.
232. Id.
233. Id.
234. Id. at 775–76.
235. Id.
236. Id.
237. Bundy, supra note 23, at 134.
238. 361 P.2d 906 (Cal. 1961).
239. Bundy, supra note 23, at 134.
240. Glenn Turner I, 348 F. Supp. at 774–75.
241. Glenn Turner II, 474 F.2d 476, 480 (9th Cir. 1973).
2068 FORDHAM LAW REVIEW [Vol. 88
In SEC v. Glenn W. Turner Enterprises, Inc. (Glenn Turner II),
242
the court
found that the “solely” requirement “should not be read as a strict or literal
limitation on the definition of an investment contract.”
243
Rather, the test
should be read realistically “so as to include within the definition those
schemes which involve in substance, if not form, securities.”
244
This is
particularly so in light of the remedial purposes of the federal securities laws,
the policy of broadly protecting the public, and the Supreme Court’s mandate
that securities should be defined flexibly.
245
The Ninth Circuit thus relaxed
the meaning of “solely,” asking instead “whether the efforts made by those
other than the investor are the undeniably significant ones, those essential
managerial efforts which affect the failure or success of the enterprise.”
246
Similarly, in SEC v. Koscot Interplanetary, Inc.,
247
the Fifth Circuit
conducted a careful analysis of the Howey decision and the authority relied
upon by the Supreme Court in developing the test.
248
It concluded that
“solely” should not be read literally.
249
Importantly, the court recognized
that too literal an interpretation of the Howey test would frustrate, rather than
serve, the remedial purposes of the federal securities laws.
250
This more functional approach to Howey is now the majority position.
251
Using this test, however, federal courts have come to varying conclusions
about whether pyramids constitute securities.
252
2. Differing Interpretations of Managerial Efforts
While the circuits have liberalized the last prong of Howey, the courts still
differ with respect to the quantity and quality of efforts made by the investor
that will preclude a finding of a security under the test.
253
242. 474 F.2d 476 (9th Cir. 1973).
243. Id. at 482.
244. Id.
245. Id.
246. Id. (noting that a rule that precludes a finding of an investment contract based solely
on the fact that investors were required to exert some efforts would frustrate, rather than serve,
the purposes of the Securities Act of 1933).
247. 497 F.2d 473 (5th Cir. 1974).
248. Id. at 480.
249. Id.
250. Id. at 479.
251. See Farha, supra note 196, at 174; see, e.g., SEC v. SG Ltd., 265 F.3d 42, 54–55 (1st
Cir. 2001) (noting that the courts of appeals have universally declined to interpret “solely”
literally in this context); Albanese v. Fla. Nat’l Bank of Orlando, 823 F.2d 408, 410–12 (11th
Cir. 1987).
252. See, e.g., Webster v. Omnitrition Int’l, Inc., 79 F.3d 776 (9th Cir. 1996); Glenn Turner
II, 474 F.2d 476 (9th Cir. 1973); SEC v. Int’l Loan Network, Inc. (Loan Network I), 770 F.
Supp. 678 (D.D.C. 1991), aff’d, 968 F.2d 1304 (D.C. Cir. 1992).
253. See Stephen C. Hillard & Peter A. Ricciardelli, Investment Contracts Under the
Colorado and Uniform Securities Acts, 49 U.
COLO. L. REV. 391, 406 (1978) (observing that
interpretation and application of Howey’s third prong has been somewhat elusive, with courts
focusing on different aspects of the enterprise in question); Nancy K. Jones, Note, Defining
an “Investment Contract” for Purposes of Alaska Blue Sky Law: Have the Alaska Courts
Stretched Their Test Beyond Meaningful Application?, 2 A
LASKA L. REV. 371, 391 (1985)
(arguing that “neither the Howey test nor its progeny have quantified the amount of managerial
2020] HYBRID SECURITIES AND PYRAMID FRAUD 2069
For instance, in Kerrigan v. ViSalus, Inc.,
254
the court focused extensively
on the breadth of activities that the scheme promoters represented would be
required of distributors who desired success in the program.
255
The case
dealt with a multilevel retailer of powdered weight loss shakes and associated
products.
256
The court began its discussion by concluding that, because of
the emphasis that ViSalus placed on recruitment, the market for the products
was saturated.
257
As such, nearly all of the distributors who had joined
between 2010 and 2013 lost their money.
258
The court concluded that,
because of the focus on recruitment and its compensation structure, the
ViSalus program was a pyramid scheme.
259
However, in moving to the
securities question, the court concluded that it could not find, as a matter of
law, that the final Howey prong was satisfied.
260
In particular, the court
looked to the company’s statements, which detailed the various marketing,
administrative, and sales activities distributors might engage in.
261
Moreover, in all of its promotional materials, ViSalus heavily emphasized
the role that individual distributors would play in their own success.
262
Despite noting that ViSalus directly provided distributors with essential
marketing materials and training, the court found it significant that ViSalus
represented that it offered participants a great degree of freedom in choosing
how to promote or sell the products or the program.
263
Accordingly, the court
held that it was not clear that the distributors’ efforts were insignificant and
that, therefore, the Howey test was not met.
264
The Kerrigan court’s
reasoning exemplifies the approach to Howey that looks primarily to the
amount of work expected of a potential investor, as represented to them by
the program promoters and promotional or recruitment materials.
265
Other courts, however, have focused more specifically on whether the
work of participants is largely ministerial or managerial.
266
For example, in
control that an investor may exercise before a scheme will be deemed an investment
contract”).
254. 112 F. Supp. 3d 580 (E.D. Mich. 2015).
255. See id. at 598–99.
256. Id. at 586–87.
257. Id. at 588.
258. Id.
259. Id. at 593–95.
260. Id. at 599.
261. Id. at 598–99.
262. Id. at 599 (“These activities may include hosting events such as challenge parties;
purchasing and using promotional materials; utilizing and paying for direct mail and print
materials . . . purchasing inventory . . . and recruiting, training and mentoring customers and
other individual promoters . . . .”).
263. Id. at 598–99.
264. Id. The court nonetheless acknowledged that the allegations in the complaint did
suggest that the distributors’ chances of profit were substantially dependent upon the
promotional work of ViSalus and its employee network. Id. at 598.
265. Accord Villeneuve v. Advanced Bus. Concepts Corp., 730 F.2d 1403, 1404 (11th Cir.
1984); Bitter v. Hoby’s Int’l, Inc., 498 F.2d 183, 184–85 (9th Cir. 1974); United States v.
Holtzclaw, 950 F. Supp. 1306, 1316–17 (S.D.W. Va. 1997).
266. See, e.g., Martin v. T. V. Tempo, Inc., 628 F.2d 887, 890–91 (5th Cir. 1980); Miller
v. Cent. Chinchilla Grp., Inc., 494 F.2d 414, 416–18 (8th Cir. 1974); Lytikainen v. Schaffer’s
2070 FORDHAM LAW REVIEW [Vol. 88
Mitzner v. Cardet International, Inc.,
267
the court acknowledged the role of
the distributors and area managers in the company’s MLM product delivery
program.
268
Like in Kerrigan, the court further recognized that the
participant agreements reflected an expectation that participants were
responsible for recruiting others, distributing brochures, picking up orders,
and delivering goods sold.
269
Nonetheless, the Mitzner decision turned on
the court’s conclusion that the participants’ efforts were purely ministerial.
270
In particular, despite the fact that the participants’ success was dependent
upon their performance of certain tasks, the court underscored that the
company was responsible for selecting the type, quality, and nature of goods
sold, as well as providing marketing and advertising materials.
271
The
distributors and area managers were therefore bound by the rules and
procedures set by the company and not empowered to make meaningful or
independent business decisions.
272
Accordingly, even though the participants were told explicitly to expect to
make significant efforts, the Mitzner court found that the third prong of
Howey was not satisfied because such efforts were ministerial, not
managerial.
273
However, the respective responsibilities of the company and
of the distributors in Mitzner closely resembled the facts in Kerrigan.
Nonetheless, the two courts came to opposite conclusions regarding the
existence of a security.
274
Such cases reflect courts’ inconsistent application
of Howey’s third prong to pyramid schemes.
B. Risk Capital Analysis and the Hawaii Market Center Test
In response to the perceived rigidity of the Howey test, state courts began
to formulate alternative investment contract tests.
275
One such alternative,
the “risk capital test,” has been articulated in several different ways by both
federal and state courts.
276
However, all of the variations derive from a
common notion that the “subjection of the buyer’s initial value to the risks of
an enterprise with which he is not familiar and over which he exercises no
control seems to be the ‘economic reality’ which most clearly creates a need
Bridal LLC, No. CV-18-04685-PHX-DWL, 2019 WL 3890313, at *3 (D. Ariz. Aug. 19,
2019).
267. 358 F. Supp. 1262 (N.D. Ill. 1973).
268. Id. at 1267–68.
269. Id. at 1267.
270. Id. at 1267–68.
271. Id. at 1268.
272. Id. The court also gave weight to the fact Cardet emphasized to potential participants
that no experience was necessary. Id.
273. Id. at 1268–69; cf. Ranieri v. AdvoCare Int’l, L.P., 336 F. Supp. 3d 701, 714 (N.D.
Tex. 2018) (concluding that distributors’ personal efforts to recruit new members were more
than nominal or ministerial, precluding a finding that the scheme promoters were responsible
for managerial efforts).
274. See Mitzner, 358 F. Supp. at 1268–69; Kerrigan v. ViSalus, Inc., 112 F. Supp. 580,
599 (E.D. Mich. 2015).
275. See Pease, supra note 198, at 119.
276. See Wiebolt v. Metz, 355 F. Supp. 255, 259 (S.D.N.Y. 1973) (commenting that the
risk capital approach has not been applied uniformly).
2020] HYBRID SECURITIES AND PYRAMID FRAUD 2071
for the special fraud procedures, protections, and remedies of the securities
laws.”
277
1. The Development of Risk Capital Analysis
Justice Roger J. Traynor is generally credited with articulating the first risk
capital analysis in Silver Hills Country Club v. Sobieski, which arose as an
action under California’s securities laws.
278
There, the defendants sought
capital to develop and finance a country club by selling memberships in the
club.
279
Under the developers’ plan, the cost of a membership increased as
the club grew and new facilities were added.
280
Members were responsible
for monthly dues and had no rights to the club’s income or assets.
281
Yet,
membership entitled investors to use all club facilities, except for the golf
course, and membership could only be transferred to individuals approved
by the club’s board of directors.
282
The club developers argued that
memberships were simply contracts for the sale of personal recreational
services.
283
Accordingly, they posited that the memberships did not fall
within the scope of the securities laws because they were not purchased for
investment.
284
Nevertheless, Justice Traynor concluded that securities protection was
intended “to afford those who risk their capital at least a fair chance of
realizing their objectives in legitimate ventures.”
285
The membership
therefore constituted a security because the benefits of membership would
only be realized if investors, along with other purchasers, subjected their
capital to the risks of the enterprise.
286
Even though the interest was labeled
a membership, the risk of loss was no different than that of a stock, bond, or
note.
287
In sum, Silver Hills introduced the idea that, where capital solicited
from investors is subjected to the risks of an enterprise, the risk of loss is
shifted to members of the public, who are then entitled to the protections of
the securities laws.
288
The rationale from Silver Hills was further refined by the Hawaii Supreme
Court in State v. Hawaii Market Center, Inc.
289
In Hawaii Market Center,
the court faced a “founder-membership” plan similar to the one in Silver
Hills: the defendants sought to open a retail store that would only sell goods
277. Ronald J. Coffey, The Economic Realities of a “Security”: Is There a More
Meaningful Formula?, 18 C
ASE W. RES. L. REV. 367, 412 (1967).
278. Silver Hills Country Club v. Sobieski, 361 P.2d 906 (Cal. 1961).
279. Id. at 906–07.
280. Id. at 907.
281. Id.
282. Id.
283. Id.
284. Id.
285. Id. at 908.
286. Id.
287. Id.
288. See Hillard, supra note 253, at 409.
289. 485 P.2d 105 (Haw. 1971).
2072 FORDHAM LAW REVIEW [Vol. 88
to individuals who had purchased authorization cards.
290
To finance the
development of the store, the promoters recruited “founder-members.”
291
To
become a founder-member, one would purchase either a sewing machine or
a cookware set, each with a $70 wholesale value, for $320.
292
In return, the
member received: authorization to shop at the store once it became
operational, fifty authorized buyer’s cards to be distributed by the investor to
others, the right to earn a 10 percent commission on any sale made by
shoppers using one of the investor’s distributed cards, as well as fees and
compensation for bringing others into the program as founder-members or
higher-level distributors.
293
In determining whether the scheme constituted a security, the Hawaii
Market Center court rejected the Howey test, arguing that it fostered a
mechanical and narrow notion of investor participation.
294
Fundamentally,
the court reasoned that, under the Howey formula, courts become entrapped
in semantics and fail to consider the overriding question of whether the
protection of the securities laws should apply to the enterprise in question.
295
Instead, the court held that, for purposes of the Hawaii Uniform Securities
Act,
[A]n investment contract is created whenever:
(1) an offeree furnishes initial value to an offeror, and
(2) a portion of this initial value is subjected to the risks of the enterprise,
and
(3) the furnishing of the initial value is induced by the offeror’s promises
or representations which give rise to a reasonable understanding that a
valuable benefit of some kind, over and above the initial value, will accrue
to the offeree as a result of the operation of the enterprise, and
(4) the offeree does not receive the right to exercise practical and actual
control over the managerial decisions of the enterprise.
296
Particularly significant for the issue of pyramid schemes was the
observation that courts should concentrate on the quality of participation and
the degree of control over the enterprise exercised as a function of that
participation.
297
290. Id. at 107.
291. Id.
292. Id.
293. Id.
294. Id. at 108.
295. Id.
296. Id. at 109.
297. Id. at 111. This concept has been incorporated by case law or statute by several states.
See, e.g., NNN Durham Office Portfolio 1, LLC v. Grubb & Ellis Co., No. 10-CVS-4392,
2016 WL 7489690, at *15 (N.C. Super. Ct. Dec. 29, 2016); King v. Pope, 91 S.W.3d 314, 324
(Tenn. 2002) (concluding that the Hawaii Market Center test is preferable because, inter alia,
it puts the requirement of managerial control in explicit, more easily comprehensible terms).
2020] HYBRID SECURITIES AND PYRAMID FRAUD 2073
2. Reception by the Federal Courts
Although Howey remains the definitive rule, many federal courts
recognize risk capital analysis as a useful tool for defining various forms of
securities.
298
With respect to investment contracts and the “efforts of others”
prong, the court in SEC v. Aqua-Sonic Products Corp.
299
observed that the
theory underlying the Silver Hills and Hawaii Market Center risk capital tests
could be used to further define or refine investor passivity or dependence
under Howey.
300
Moreover, it concluded that the risk capital concept helped
to distinguish between enterprises that appear more like a traditional offer to
invest—because the risk of loss is dependent upon the competence of
others—from those in which the investor buys the right to conduct a business
and exercises practical control over his or her resources.
301
Similarly, in determining whether the defendant’s MLM business was a
pyramid and an investment contract, the court in In re Bestline Products
Securities & Antitrust Litigation
302
applied the Howey test but engaged in a
lengthy discussion regarding the significance of risk that the individual
distributors assumed as a function of their relationship to the company.
303
Significantly, in its analysis of Howey’s third prong, the court thoroughly
considered the degree of control retained by distributors and the relationship
of the distributor’s control to their chances of success, as opposed to simply
the nature or extent of their efforts.
304
The concept of risk capital has also been employed to determine whether
a promissory note may be classified as a security.
305
Some courts look to the
degree of risk, subject to the entrepreneurial or managerial efforts of others,
when distinguishing between promissory notes for ordinary commercial
loans and investments that fall under the protection of the securities acts.
306
Additionally, the Fifth Circuit uses a risk capital approach when asking
whether, under Howey, the efforts of general partners are insignificant
enough to warrant finding a security.
307
Under that approach, the third prong
298. See, e.g., Elson v. Geiger, 506 F. Supp. 238 (E.D. Mich. 1980); Mr. Steak, Inc. v.
River City Steak, 324 F. Supp. 640 (D. Colo. 1970), aff’d, 460 F.2d 666 (10th Cir. 1972).
299. 524 F. Supp. 866 (S.D.N.Y. 1981).
300. Id. at 866, 878.
301. Id.
302. 412 F. Supp. 732 (S.D. Fla. 1976), rev’d sub nom. Piambino v. Bailey (In re Bestline
Prods. Sec. & Antitrust Litig.), 610 F.2d 1306 (5th Cir. 1980).
303. Id. at 750–53.
304. Id. at 751–52 (“The class Plaintiffs are not manufacturers or producers of soap, and
the terms and conditions of their participation in the Bestline National Marketing Plan are
controlled by Bestline . . . . Bestline’s failure would not only render its distributorships
worthless, but would effectively put the distributor out of business as a separate or independent
entity.”).
305. See, e.g., Great W. Bank & Tr. v. Kotz, 532 F.2d 1252, 1256–57 (9th Cir. 1976);
C.N.S. Enters., Inc. v. G. & G. Enters., Inc., 508 F.2d 1354, 1249 (7th Cir. 1975).
306. See, e.g., Danner v. Himmelfarb, 858 F.2d 515, 519 (9th Cir. 1988); Great W. Bank,
532 F.2d at 1256–57; Elson v. Geiger, 506 F. Supp. 238, 241 (E.D. Mich. 1980), aff’d, 701
F.2d 176 (6th Cir. 1982).
307. E.g., SEC v. Arcturus Corp., 928 F.3d 400, 410–11 (5th Cir. 2019). For a discussion
of the significance of the “efforts of others” prong in the context of general partnerships, see
2074 FORDHAM LAW REVIEW [Vol. 88
of Howey is satisfied when: (1) the parties’ agreement gives so little power
to the partner that it in fact distributes power in the same way as a limited
partnership; or (2) the partner so lacks experience and knowledge of business
affairs that he is not capable of intelligently exercising his partnership
powers; or (3) the partner so heavily depends on the unique entrepreneurial
or managerial skills of the promoter or manager that he cannot replace that
promoter or manager, or otherwise exercise meaningful partnership
power.
308
Further, the SEC has endorsed the risk capital formulation set out in
Hawaii Market Center as applicable to the federal securities laws and
consistent with the Supreme Court’s emphasis on the remedial character of
the federal securities acts.
309
Significantly, the SEC noted that a security
exists where the responsibilities or powers of the investor have little direct
effect on their receipt of promised benefits.
310
Further, the SEC urged that
even the performance of financially significant duties, which manifestly
contribute to the success of the venture, may not alter the security analysis if
the investor lacks significant control over the use of his investment.
311
Nonetheless, despite its acceptance on the state level and the use and
discussion of risk capital analysis on the federal level, no risk capital test has
formally been adopted to replace Howey.
312
Further, given the opportunity,
in United Housing Foundation, Inc. v. Forman,
313
the Supreme Court
declined to adopt a risk capital analysis.
314
The Court did not, however, foreclose the possibility of adopting a risk
capital test in a more appropriate case.
315
Rather, the Court observed that in
the Forman fact pattern, it was clear that the plaintiffs had not taken on any
significant risk because they were able to recover their investment in full at
any time.
316
Therefore, if the Court were inclined to apply the risk capital
test, it would not do so in the instant case.
317
However, as the Ninth Circuit
Douglas M. Fried, Note, General Partnership Interests as Securities Under the Federal
Securities Laws: Substance over Form, 54 F
ORDHAM L. REV. 303 (1985).
308. Williamson v. Tucker, 645 F.2d 404, 424 (5th Cir. 1981).
309. Release, supra note 186, at 23,290 (stating the commission’s position that the
conclusion of the Hawaii Market Center court is fully consistent with the Supreme Court’s
remedial approach to interpretation of the federal securities laws).
310. Id. at 23,289.
311. Id.
312. See Pareja, supra note 26, at 100. Further, there is some disagreement among the
federal courts as to whether risk capital analysis should be employed only when assessing
investments made as part of initial capitalization.
HAZEN, supra note 154, § 1:55; see also Sec.
Adm’r v. Coll. Assistance Plan (Guam) Inc., 533 F. Supp. 118, 123 (D. Guam 1981). The
question may have arisen, however, because in many of the early state cases that developed
and applied the risk capital test, including Silver Hills and Hawaii Market Center, the facts
involved initial capitalization at the start of the enterprise. See, e.g., Jet Set Travel Club v.
Corp. Comm’r, 535 P.2d 109 (Or. Ct. App. 1975); State ex rel. Healy v. Consumer Bus. Sys.,
Inc., 482 P.2d 549 (Or. Ct. App. 1971).
313. 421 U.S. 837 (1975).
314. Id. at 857.
315. See id.
316. Id. at 857 n.24.
317. Id.
2020] HYBRID SECURITIES AND PYRAMID FRAUD 2075
pointed out in Great Western Bank & Trust v. Kotz,
318
the Supreme Court
has used a form of risk capital analysis to distinguish between annuity
investment contracts, which are covered by the securities laws, and insurance
contracts, which are exempt from registration requirements.
319
III.
JOINING FORCES: A COMBINED HOWEY–HAWAII MARKET CENTER TEST
As this Note has illustrated, pyramid fraud in the United States is
substantial and difficult to regulate.
320
Victims’ documented reticence to
come forward also exacerbates the problem, impeding government actors
from detecting and shutting down illegal pyramids.
321
The federal securities
laws are fruitful and promising avenues for enforcement.
322
Classification
as a security brings with it significant liability and regulatory costs, as well
as the possibility of criminal penalties.
323
Therefore, where pyramid scheme
promoters believe that their schemes will fall within the ambit of the federal
securities laws, they are more likely to be deterred from forming such
schemes in the first instance.
324
Additionally, the increased availability of
securities enforcement actions would make it more likely that victims would
recover their losses because the SEC may seek disgorgement of profits.
325
Yet, despite the liberalization of Howey’s “efforts of others” prong, as the
discussion in Part II demonstrated, there continues to be inconsistency among
the federal courts as to how to categorize and analyze the efforts of pyramid
scheme participants and distributors.
326
Accordingly, the application of the
federal securities laws to pyramid schemes remains unsettled. Moreover,
under Howey’s third prong, several pyramid schemes have escaped the reach
of the federal securities laws, despite bearing the economic characteristics of
securities.
327
As a result, pyramid scheme formation is not effectively
deterred by the federal securities laws.
Part III.A argues that pyramid schemes bear the fundamental economic
characteristics of securities and that pyramid fraud is precisely the kind of
318. 532 F.2d 1252 (9th Cir. 1976).
319. Id. at 1257 n.2 (first citing SEC v. United Benefit Life Ins. Co., 387 U.S. 202, 211
(1967) (finding that the assumption of some risk by an insurance company cannot by itself
bring an annuity contract within the insurance exemption); then citing SEC v. Variable
Annuity Life Ins. Co. of Am., 359 U.S. 65, 71–73 (1959) (finding that in the instant case,
because the investment instrument saddled the investor with all of the risk, the annuity was
classified as a nonexempt security which was required to be registered with the SEC)).
320. See supra Parts I.B, II.
321. See supra Part I.B.
322. See supra Part I.C.3. But see Pareja, supra note 26, at 102–03 (arguing that SEC
enforcement is made more difficult by the agency’s lack of resources and that the preclusion
of punitive damages in securities class actions make private causes of action less desirable).
323. See Hillard, supra note 253, at 429; supra Part I.
324. See Bundy, supra note 23, at 124.
325. See supra Part I.C.3; see, e.g., SEC v. DFRF Enters. LLC, 384 F. Supp. 3d 129, 131
(D. Mass. 2019).
326. See supra Part II.A.
327. See, e.g., Ranieri v. AdvoCare Int’l, L.P., 336 F. Supp. 3d 701, 713–15 (N.D. Tex.
2018); SEC v. Int’l Heritage, Inc., 4 F. Supp. 2d 1378, 1383 (N.D. Ga. 1998); United States
v. Holtzclaw, 950 F. Supp. 1306, 1313, 1317 (S.D.W. Va. 1997).
2076 FORDHAM LAW REVIEW [Vol. 88
deceptive investment opportunity that securities law was designed to target.
In Part III.B, this Note further argues that Howey’s third prong leads to both
inconsistent and unprincipled results when applied to pyramid schemes and
that it is not a useful analytical tool in that context. Part III.C urges the federal
courts to replace the “efforts of others” prong from Howey with the final
prong of the Hawaii Market Center test in cases involving alleged pyramids.
Finally in Part III.D, this Note demonstrates why this combined Howey–
Hawaii Market Center test produces more principled results that are
consonant with the purposes, policies, and spirit of federal securities
regulation.
A. Why Securities Protections Should Properly Be Applied to Pyramid
Schemes
Congress enacted the securities laws to broadly protect the investing public
from meaningful misstatements, omissions, and fraud.
328
The history of
securities regulation reveals that the laws are most principally concerned with
investor manipulation and victimization.
329
From the beginning, the aim was
to require disclosure of material information, ensuring that both investors and
the marketplace had sufficient information to make intelligent investment
decisions.
330
While the federal securities laws are not a broad remedy for all forms of
fraud, pyramid schemes bear all of the hallmarks of the misleading
investment fraud that these laws were designed to protect against. Pyramids
are fundamentally money transfer schemes.
331
Thus, they do not generate
genuine economic value because they do not produce revenue through the
sale of goods or services.
332
Rather, they almost invariably involve
fraudulent misrepresentations and cause financial losses to the great majority
of those that sign up to participate.
333
Further, the convoluted and obfuscated
nature and structure of such schemes makes it incredibly difficult for the
average potential participant to adequately assess the risk of loss or the
legality of the venture.
334
In sum, pyramids possess all of the evils that the
federal securities laws were intended to cure: fraud, misrepresentation,
deceptive and spurious investments, and inadequate disclosure.
335
328. Bundy, supra note 23, at 124.
329. Elaine A. Welle, Freedom of Contract and the Securities Laws: Opting out of
Securities Regulation by Private Agreement, 56 W
ASH. & LEE L. REV. 519, 534 (1999).
330. Id.; see also id. at 539 (“Congress enacted the securities laws to promote socially-
directed values, such as fairness, equity, the protection of investors, the deterrence of fraud,
and the promotion of ethical standards.”).
331. See Keep & Vander Nat, supra note 49, at 196.
332. See Bosley & Knorr, supra note 73, at 82; Valentine, supra note 20.
333. See supra Parts I.A.2, I.B.
334. See Pareja, supra note 26, at 86–88; Bundy, supra note 23, at 123–28; Note, supra
note 27, at 1261.
335. See Richard S. Hardy, Comment, The New Gold Rush: The Last Frontier of the
Securities Laws?, 29 S
ANTA CLARA L. REV. 359, 364–65 (1989) (discussing why Congress’s
concerns about uninformed investors purchasing worthless and fraudulent investments
motivated the creation of the federal securities regime).
2020] HYBRID SECURITIES AND PYRAMID FRAUD 2077
B. The Relationship Between Investor Effort and Investor Control
The history and emphasis of the federal securities laws reflect the notion
that governmental protection of investors is warranted where the investor is
involved and, therefore, informed.
336
Securities law’s heavy emphasis on
disclosure is based on the notion that investors are adequately protected when
all relevant aspects of an investment are fully and fairly communicated.
337
Such disclosure offers investors the means to evaluate the merits of an
investment opportunity themselves.
338
It follows that the danger of fraud is
considerably lessened when the investor subjects capital to an enterprise over
which he exercises meaningful control because such an investor also
inevitably remains informed of material information about his investment.
339
Thus, the “efforts of others” prong does not separate passive from active
investors for its own sake.
340
Rather, it is a means to identify investors who
retain no direct control over the policy decisions affecting their funds, in
which case the law should force disclosure of material information about the
enterprise.
341
Where, on the other hand, the investor exercises meaningful
control through participation, there is less of a need for governmental
protection
342
and the need for forced disclosure of information to enable an
investor to make an intelligent decision about the soundness of an enterprise
is significantly reduced.
343
The move away from the word “solely” in the Howey test reflects this
notion.
344
As the Supreme Court has long recognized, Congress intentionally
defined “security” in general terms.
345
Congress also acknowledged the
boundlessness of possible schemes that might arise in capital markets.
346
The securities laws, therefore, include descriptive phrases, like “investment
contract,” that are broad and flexible enough to carry out the acts’ remedial
336. See Joseph C. Long, An Attempt to Return “Investment Contracts” to the Mainstream
of Securities Regulation, 24 OKLA. L. REV. 135, 171 (1971); see also Coffey, supra note 277,
at 396.
337. H
AZEN, supra note 154, §§ 1.16–1.18.
338. Id.
339. Coffey, supra note 277, at 396.
340. See id. at 398–400; Long, supra note 336, at 154–55, 170–72; Bundy, supra note 23,
at 135.
341. See Bundy, supra note 23, at 135; see also Long, supra note 336, at 154–55, 170–72.
342. See SEC v. Galaxy Foods, Inc., 417 F. Supp. 1225, 1239 (E.D.N.Y. 1976) (noting that
a flexible securities test “is consistent with the purpose of the securities laws ‘to protect
passive, uninformed investors’” (quoting Mr. Steak, Inc. v. River City Steak, Inc., 324 F.
Supp. 640, 644 (D. Colo. 1970), aff’d, 460 F.2d 666 (10th Cir. 1972)).
343. Long, supra note 336, at 171 (noting also that securities are unique among investment
vehicles because investors lose control and that this was one of the principal reasons for the
emergence of securities regulation); see United States v. Leonard, 529 F.3d 83, 91 (2d Cir.
2008) (concluding that the essential question in making a security determination is whether an
investor is able to exercise meaningful control over his investment); Glenn Turner I, 348 F.
Supp. 766, 775 (D. Or. 1972) (noting that the cases considering the meaning of “investment
contract” have consistently emphasized whether the investor has substantial control to
influence the success of the enterprise), aff’d, 474 F.2d 476 (9th Cir. 1973).
344. See Monaghan, supra note 224, at 2137.
345. Welle, supra note 329, at 535–36.
346. Id.
2078 FORDHAM LAW REVIEW [Vol. 88
purposes and afford full protection to the investing public.
347
A literal
reading of the word “solely” is therefore inconsistent with the view that
inquiries into the existence of a security should be flexible and centered on
economic realities.
348
On the other hand, risk of loss without control is one
of the essential characteristics of the economic reality of a security.
349
This
notion can be traced back to SEC v. C.M. Joiner Leasing Corp.,
350
where the
Supreme Court recognized that the degree to which the buyer’s investment
was tied to the success of the enterprise was critically relevant to the buyer’s
need for the protection of the federal securities laws.
351
The economic reality of pyramid schemes is that participants make
investments—sometimes substantial ones—and yet, returns are based on the
continuous recruitment of new participants and mathematically
unsupportable geometric progression.
352
Since participants have no control
over the model, distributors’ returns are based, to a substantial degree, on the
decisions and efforts of others.
353
Accordingly, the extent, nature, and
quality of a participant’s efforts frequently have no bearing on the success of
their investment.
354
Howey’s final prong, which courts have generally read to inquire into the
quantity and quality of efforts, therefore, makes little sense in the context of
pyramid schemes.
355
In illegal pyramids, a participant may devote himself
tirelessly to the sale of a sham product and the development of a customer
base and management of a business.
356
Yet, his returns still turn on market
saturation and downline recruitment.
357
Thus in a pyramid scheme, an
investor may very well contribute managerial or essential efforts, and yet,
such efforts are no protection against the risk of loss inherent in the scheme
or the lack of information about the true nature of the program.
358
Regardless
347. Id.
348. See SEC v. Arcturus Corp., 912 F.3d 786, 793 (5th Cir. 2019); Bailey v. J.W.K. Props.,
Inc., 904 F.2d 918, 920 n.3 (4th Cir. 1990); Glenn Turner II, 474 F.2d 476, 482 (9th Cir. 1973).
349. Coffey, supra note 277, at 375, 381.
350. 320 U.S. 344 (1943).
351. Coffey, supra note 277, at 381.
352. See Villeneuve v. Advanced Bus. Concepts Corp., 698 F.2d 1121, 1126 (11th Cir.
1983) (Kravitch, J., dissenting); Gastwirth & Bhattacharya, supra note 72, at 528; Valentine,
supra note 20; Fast Answers: Pyramid Schemes, supra note 89.
353. See Villeneuve, 698 F.2d at 1126 (Kravitch, J., dissenting); SEC v. Koscot
Interplanetary, Inc., 497 F.2d 473, 485 (5th Cir. 1974); see, e.g., Smith v. LifeVantage Corp.,
No. 2:18-CV-00621, 2019 WL 6616308, at *2–3 (D. Utah Dec. 5, 2019); Shuxin Li v. EFT
Holdings, Inc., No. CV-13-8832, 2015 WL 12747812, at *2 (C.D. Cal. July 21, 2015).
354. See Gastwirth & Bhattacharya, supra note 72, at 528–30 (demonstrating “how
dependent a participant’s potential earnings are to their time of entry in the process”);
Whitford, supra note 94, at 694 (observing that once pyramid schemes reach an inevitable
point of saturation, “efforts of the investor are simply irrelevant, even if he spends all his time
in futile efforts to sell the unsellable” (quoting Glenn Turner I, 348 F. Supp. 766, 776 (D. Or.
1972))).
355. See supra Part II.A; see also Coffey, supra note 277, at 395 (arguing that if the risk
factor of an investment is not properly identified “certain transactions involving genuine risk
to the buyer’s initial value might escape security classification”).
356. See supra Part II.A.
357. See Loan Network II, 968 F.2d 1304, 1308–09 (D.C. Cir. 1992).
358. See, e.g., Mitzner v. Cardet Int’l, Inc., 358 F. Supp. 1262, 1267–68 (N.D. Ill. 1973).
2020] HYBRID SECURITIES AND PYRAMID FRAUD 2079
of how much effort a pyramid scheme requires of distributors, those efforts
rarely ever determine their returns; the primary factor that determines
whether a pyramid participant earns money is the time at which they enter
the scheme.
359
C. Harmonizing Howey and Hawaii Market Center: Incorporating
Practical and Actual Control
In the context of pyramid schemes, incorporating the fourth prong of the
Hawaii Market Center test, which focuses on investor control, would bring
the Howey test into accord with the purposes of the federal securities laws
and would further the goal of investor protection.
The final prong of the Hawaii Market Center test requires that “the offeree
does not receive the right to exercise practical and actual control over the
managerial decisions of the enterprise.”
360
As applied, this test focuses on
practical and actual managerial control as opposed to managerial efforts.
361
For instance, in Wieboldt v. Metz,
362
the district court discussed the
application of the risk capital test to a franchise agreement.
363
The court
noted that in a typical franchise, the franchisee has decision-making power
over choices that affect the economic viability of his enterprise.
364
In
contrast, under the risk capital test, where the franchisee exercises no
meaningful control over his venture, an investment contract exists.
365
Similarly, in Securities Administrator v. College Assistance Plan (Guam),
Inc.,
366
the court adopted the Hawaii Market Center test, reasoning that the
test was more concerned with practical and actual control, recognizing the
importance of weighing not just the degree but also the effect of investor
participation.
367
If courts evaluating an alleged pyramid scheme focus on whether the
investor retained control to influence the success of his investment, they can
avoid the danger of arbitrarily excluding certain schemes from the protection
of the federal securities laws.
368
For many investment vehicles, such as the
359. See Whitford, supra note 94, at 694.
360. State v. Haw. Mkt. Ctr., Inc., 485 P.2d 105, 109 (Haw. 1971).
361. See Note, supra note 27, at 1286 (arguing that the Hawaii Market Center test
overcame some of the limitations of the Howey test by examining investor control, rather than
investor effort, in the production of profit).
362. 355 F. Supp. 255 (S.D.N.Y. 1973).
363. Id. at 259–60.
364. Id. at 260.
365. Id.
366. 533 F. Supp. 118 (D. Guam 1981).
367. Id. at 123. Some courts have commented that there is no longer a meaningful
difference between the final prong of Howey and the final prong of the Hawaii Market Center
test because Howey has been made more flexible subsequent to the Koscot and the Glenn
Turner cases. However, the distinction between efforts or labor and control “does become
important with the development of new plans specifically drafted to fall just beyond the Howey
definition.” Long, supra note 336, at 176.
368. See Long, supra note 336, at 145 (noting that after Howey, courts almost unanimously
interpreted efforts to mean any effort by the investor, regardless of the bearing it had on control
2080 FORDHAM LAW REVIEW [Vol. 88
one presented in Howey itself, efforts—or lack thereof—made by the
investor are closely correlated to the control and knowledge of the
investor.
369
However, in pyramids, investors may retain formalistic control
and exercise significant efforts, yet these efforts do not influence their
success in the scheme.
370
Therefore, with respect to alleged pyramids, it is
more useful to ask not how significant the efforts were but rather whether
those efforts had any impact on the investor’s return or lack thereof.
Accordingly, a combined Howey–Hawaii Market Center test better serves
the policies underlying Howey: emphasis on economic reality, flexibility,
and protecting investors from fraudulent schemes that are not easily
detected.
371
Because pyramids are subject to greater variation than other
forms of investment contracts and not as easily categorized, it makes sense
for courts to use a test that better captures the harm seeking to be prevented
or remediated.
372
This tailoring is already a common approach among lower courts when
they are confronted with investment vehicles that are difficult to analyze or
whose nature may be influenced by a number of variables.
373
There is
evidence that courts already vary the focus of their analysis of Howey’s last
prong, often emphasizing control over efforts, when the specific facts call for
such an analytical departure.
374
For example, looking at a sale-leaseback
program in Albanese v. Florida National Bank of Orlando,
375
the Eleventh
Circuit found that a scheme whereby investors purchased ice machines, and
then agreed to lease them back to the sellers, constituted a security.
376
In that
case, the defendant-sellers pointed to the fact that the investors retained the
right to: reject the selected locations, receive a regular accounting of
expenses and collections, and terminate the agreements under specified
conditions.
377
The defendants posited that as a result of the investors’ rights
and responsibilities, Howey’s third prong was not met.
378
The court,
however, recognized that despite the investors having retained formal
of the enterprise); Note, supra note 27, at 1293 (commenting that “[s]ecurities regulation
would benefit from substantial refinement of controlling efforts analysis”).
369. SEC v. W.J. Howey Co., 328 U.S. 293, 299–300 (1946).
370. See supra Part III.B; see also Bundy, supra note 23, at 123–25.
371. See Wayne Klein, The Idaho Securities Act: An Analysis of Idaho Courts’ Securities
Opinions, 29 I
DAHO L. REV. 95, 108 (1992) (“The use of the risk capital test, in addition to the
Howey test, gives regulator additional flexibility and enforcement authority against certain
types of fraudulent schemes.”); Jones, supra note 253, at 392 (arguing that the risk capital test
enables courts to find an investment contract where the economic realities of a security are
present, even if the literal requirements of Howey cannot be met).
372. See Bell v. Health-Mor, Inc., 549 F.2d 342 (5th Cir. 1977) (serving as an example of
the numerous possible variations on the classic pyramid model); Miller v. Cent. Chinchilla
Grp., Inc., 494 F.2d 414 (8th Cir. 1974) (same).
373. See, e.g., SEC v. Arcturus Corp., 928 F.3d 400, 409–11 (5th Cir. 2019); SEC v.
Shields, 744 F.3d 633, 643–47 (10th Cir. 2014); Hocking v. Dubois, 885 F.2d 1449, 1460–61
(9th Cir. 1989); Williamson v. Tucker, 645 F.2d 404, 421–24 (5th Cir. 1981).
374. See supra note 373.
375. 823 F.2d 408 (11th Cir. 1987).
376. Id. at 412.
377. Id. at 410–12.
378. Id.
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responsibilities by the terms of the agreement, their control was illusory.
379
Due to the nature of the arrangement, the investors had no realistic alternative
to allowing the company to manage their investments.
380
Finally, the combined test is consistent with the principles underlying the
original Howey test.
381
Howey excluded the active investor from the
disclosure and fraud protections of the securities laws, at least in part,
because an investor does not need such protection where he exercises
managerial control and therefore has access to information about the
issuer.
382
In the case of pyramids, however, the fact that the investor
participates does not in fact give him access to crucial information about the
enterprise.
383
There is, therefore, little reason to exclude such an investor
from the protection of the federal securities laws.
384
D. Clarity and Consistency: Applying the Combined Test
The proposed test provides a clearer, more concrete, and consistent
standard. It better captures the differences between legitimate MLM
companies and illegal pyramids and also leads to more analytical harmony.
Such consistency and predictability in the law benefits legitimate businesses
and also better protects the public from illegitimate, fraudulent schemes.
First, the most principled distinction between legitimate MLM companies
and illegal pyramids is whether or not revenue is based primarily on the
continuous recruitment of new members.
385
Overall continuous recruitment
is a factor almost entirely outside the control of the individual participant.
386
On the other hand, if there is an opportunity to earn income from the sale of
a marketable product, the participant has substantial control over his success
in the enterprise and thus does not subject capital to the common risk pool to
the same extent.
387
Thus, adopting the control prong of the Hawaii Market
379. Id. at 412.
380. Id.
381. See Joseph C. Long, State Securities Regulation—an Overview, 32 O
KLA. L. REV. 541,
571, 573 (citing Glenn Turner I, 348 F. Supp. 766, 776 (D. Or. 1972)). For instance, in Howey,
the Supreme Court gave the term “investment contract” the meaning that it had under state
law at the time the Securities Act was enacted. Long, supra note 336, at 141–42. The
definition was derived principally from State v. Gopher Tire & Rubber Co., 177 N.W. 937
(Minn. 1920). Id. Importantly in Gopher Tire, the investors were in fact required to devote
substantial efforts to the enterprise, yet the court found the existence of an investment contract
nonetheless. Gopher Tire, 177 N.W. at 937–38.
382. Hirsch v. DuPont, 396 F. Supp. 1214, 1222 (S.D.N.Y. 1975), aff’d, 553 F.2d 750 (2d
Cir. 1977).
383. See Pareja, supra note 26, at 86–88; Bundy, supra note 23, at 123–28; Note, supra
note 27, at 1261.
384. See Coffey, supra note 277, at 396.
385. See Koscot Interplanetary, Inc., 86 F.T.C. 1106, 1181 (1975); Walsh, supra note 20,
at 582.
386. See supra note 354 and accompanying text.
387. See Koscot Interplanetary, 86 F.T.C. at 1112 (observing that due to high market
saturation and low product demand, participants had almost no chance to recoup their initial
investments and were all but guaranteed to lose money); Whitford, supra note 94, at 694;
supra note 55 and accompanying text.
2082 FORDHAM LAW REVIEW [Vol. 88
Center test does a better job of incorporating this distinction between
legitimate MLM companies and illegal pyramids into the law and draws a
more useful line.
Second, the utility of the proposed test can be further demonstrated by
reevaluating the two divergent cases introduced in Part II, Kerrigan v.
ViSalus, Inc. and Mitzner v. Cardet International, Inc.
388
If the facts of both
cases are evaluated using the combined test, the results and reasoning become
concordant. In Kerrigan, the scheme would pass the final prong of the
proposed combined test because, while the distributors were expected to
actively recruit others, the facts show that the defendants controlled all
relevant aspects of the program and structure.
389
The plaintiffs received no
right to exercise actual or practical control because they were bound by the
sales and recruitment structure and policies.
390
As the record reflected, a
distributor could only generate at most a token income by retailing product,
yet recruitment bonuses enabled the same distributor to earn hundreds of
dollars simply by enrolling a new recruit in the program.
391
Therefore, each
distributor, for all practical purposes, was only able to generate a return based
on rewards for recruitment.
392
Unfortunately, that emphasis on recruitment
quickly produced market saturation and made it impossible for the great
majority of participants to earn such rewards, regardless of their extensive
efforts or activities.
393
These facts precluded a return on investment,
regardless of how hard each distributor worked to recruit new participants.
394
Therefore, ViSalus investors did not have the right to exercise practical or
actual control under Hawaii Market Center, satisfying the final prong of the
combined test.
Similarly, in Mitzner, the scheme would pass the final prong of the
combined test, not because the participants’ efforts were ministerial but
rather because they were not entitled to exert any significant control over the
managerial decisions of the enterprise.
395
In other words, the participants
were not empowered “to make any meaningful or independent business
decisions” that would impact the success of their investment.
396
Instead of
focusing on the distinction between managerial and ministerial tasks, asking
whether the participants lacked control over their investment’s success
388. In both cases, the respective courts found that the programs at issue satisfied the first
and second prongs of the Howey test. Kerrigan v. ViSalus, Inc., 112 F. Supp. 3d 580, 596–98
(E.D. Mich. 2015); Mitzner v. Cardet Int’l, Inc., 358 F. Supp. 1262, 1268 (N.D. Ill. 1973).
Because the decisions diverged only with respect to the third prong, the discussion here is
limited to the last prong of the proposed combined test.
389. Kerrigan, 112 F. Supp. 3d at 588.
390. Id.
391. Id. at 593.
392. Id.
393. Id. at 588.
394. Id.
395. Mitzner v. Cardet Int’l, Inc., 358 F. Supp. 1262, 1268 (N.D. Ill. 1973).
396. Id.
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provides a clearer analytical frame that is easier to apply and produces
consistent results between the two cases.
397
C
ONCLUSION
The problem of pyramid fraud is only growing. Despite the investment of
significant governmental resources, undeterred fraudsters continue to form
new pyramid schemes with growing regularity. The federal securities laws
were enacted to protect the public from precisely these kinds of
unsubstantiated, misleading, and fraudulent investment opportunities.
However, courts inconsistently applying the Howey test continue to draw
unprincipled lines and exclude pyramid schemes from the ambit of the
federal securities laws based on the red herring of investor efforts. This Note
argues not that the federal courts should ignore the role played by distributors
in pyramid schemes but rather that they should focus attention on the degree
of control that investors may exercise as a function of that participation. By
incorporating the language of the final prong of the Hawaii Market Center
test, the courts may more directly identify the economic reality of an alleged
pyramid scheme. In so doing, they can better effectuate the vital aim of
protecting the investing public whenever the fundamental characteristics of
a security are present.
397. See id. at 1264, 1267–68.
